How to Pick and When to Buy

Buy What You Know

Why is a particular stock yielding a dividend significantly higher than other stocks? There can be a number of reasons. A high dividend is often an indication of high risk. Whether the risk is real or perceived is a question that each investor must determine. Another factor may be the type of stock. If it is a Business Development Company, a Master Limited Partnership, or a Real Estate Investment Trust the high dividend is at least partially a result of the government requirement that the vast majority of the income is passed through to the stockholder/unitholder in order to maintain a corporate tax free status.

A high dividend may be a result of the price of the stock having dropped significantly due to an overall downturn in the market, a downturn in that specific sector, or bad news in that specific equity or in an equity with similar characteristics. Obviously when the price drops and the dividend stays the same the yield goes up. Again this may or may not reflect the actual valuation of the particular stock under consideration. What all of the above boils down to is know the stock that you are evaluating. Know the business it is in, know where it stands versus its competition, and know how it is performing currently versus previous quarters/years. If you don’t know what a company does, or don’t understand what it does you should eliminate it from your screening universe.

Price Considerations/Timing

Where a stock’s price is in its range is a very significant factor. Every stock moves up and down regardless of whether the market is in an upward or downward trend. Some of these moves are market driven, and some are driven by very specific actions. High yield stocks tend to fluctuate greatly prior and subsequent to the ex-dividend date. The dividend capture crowd wants to get in on the dividend. Those interested in capital gains want to buy before the pre ex-dividend rise, and sell before the ex-dividend drop. Many investors simply want to buy prior to the dividend, while others like to buy after the stock drops following the ex-dividend date. Price can also be greatly impacted when a company sells additional stock to generate funds.

Since BDCs, MLPs, and REITs have to pass through most of their profits they frequently sell additional stock to fund new growth. Very often this is perceived as a dilution and many stock holders sell right after this type of announcement. The key here is to determine whether or not it is in fact a dilution or whether the new income from the growth funded by the sale of new stock will more than overcome the increase in shares outstanding. Often the best way to make this determination is to see what has happened historically as well as looking at what the company says they plan to do with the money received from the sale of stock. In short, being aware of an individual stock’s typical price cycle and what impacts it is important in terms of timing a buy.

Statistical Metrics

Look at price earnings ratios to see where a particular equity fits among its peers. If the PE is very high compared to other companies like themselves it raises a red flag. Likewise if it is too low compared to similar outfits the question is, why? Obviously a low PE caused by an irrationally low price is the type of opportunity to look for. Metrics such as price to book value, price to sales, price to cash flow, should be looked at within the historical framework of the particular stock in question as well as the industry that it is in.

Questions that need to be asked: Is the dividend safe? Is the dividend fully supported by earnings or distributable cash flow? What percent of earnings are paid out in dividends? In manufacturing companies it is important to know the company’s debt to equity ratio. It is generally a given that it is better to have more equity than debt yielding a debt to equity ratio of less than 1. Similarly it is generally favorable to have more current assets than current liabilities, and a current ratio of 2 or more is generally a good guideline. With MLPs, REITs and BDCs, these ratios do not give as clear a picture and things such as distributable cash flow, hedging, leverage, yield curve, and interest rate trend, are as important if not more important to understand. Again, it really comes down to understanding the company under consideration.

In evaluating high yield equities, size of a company is less important than its position among its peers, its historical performance and projected future results. It is obvious, however that large well established companies that have many years of historically growing dividends are most likely safer than smaller, newer companies. However, the recent crisis on Wall Street and the fall of many giants proves that what may appear to be obvious may not be so, and what historically has been safe may not be in the future.

Analysts

Most equities are evaluated by at least one analyst and many are evaluated by four, five or more. Opinions are based on fundamentals, technical analysis, or a combination of both. There are also a number of on-line services that provide computerized analysis such as MSN Money (free) or Value Line (fee based) that plug a stock’s metrics into a formula which produces an “opinion”. Analyst ratings are interesting as often one analyst will place a buy rating on a stock while another places a sell rating on the same stock based on the same information. While looking at analysts’ opinions provides a helpful background check and is a source of thought provoking information, they are not a substitute for your own due diligence and personal evaluation.

No one knows what your own personal criteria for buying, selling or holding a stock are better than you. No one knows your tolerance for risk better than you. No one knows how much money you have to allocate toward a particular sector or equity more than you. So while it is informative to look at analysts’ reports, remember that they are only opinions, and if you do your homework your opinion can be as good or better than theirs! Remember, no one cares more about your money than you do!

Copyright 2009 Boyd Investment Holdings LLC. All rights reserved worldwide. Visit the High Yield Dividend Stock Report for further articles and a regularly updated high yield dividend stock list: http://bihdividends.blogspot.com. This blog is dedicated to assisting investors with their due diligence in the highly volatile and often misunderstood category of high yield dividend investing as part of a diversified investment program.

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