Bear market investing
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14. Bear-proofing - high yield shares
A high yield share is a share which pays a high dividend relative to its share price.
The yield is calculated by dividing the annual dividend per share (dps) by the current share price. So a company paying a dividend of 2.1p per share on shares trading at 150p, has a dividend yield of 2.10/150 = 1.4%.
Other things being equal, you'd prefer a high yield to a low yield share because you'd be getting a higher income relative to the capital you have locked up in the shares.
In bull markets yields are largely ignored because investors tend to focus on capital appreciation - the increase in value of their shareholding through rises in the share price. But when share prices are static, or falling, there isn't any capital appreciation, and dividends become a more important part of the 'total return':
- A share whose price falls -2%, and which has a 2% yield, produces a total return of 0%.
- A share whose price falls -2%, but which has a 6% yield, produces a total return of 4%.
In bear markets, with share prices going sideways or down, the dividend yield can mean the difference between a negative total return and a positive one.
Pack your portfolio with high yield stocks then?
Not necessarily. High yielding stocks can be good bear market investments, but they can also be treacherous. The high yield may mean that the company is paying out too high a proportion of its profits in dividends and at some point will need to cut the payment. If that happens, not only will your dividend income be lower than you expected, but the share price could drop through the floor. The City hates it when companies cut their dividends.
So an important part of high yield investing is to make sure that the dividend implied by the current dividend yield is 'safe'. The important checks are:
- Dividend cover of more than 1.8
Dividend cover is a measure of how many times the dividend per share (dps) is covered by earnings per share (eps). Effectively, it tells you how easily the company can pay dividends out of its profits. All you do is divide eps by dps. So a company with an eps of 10p and a dps of 5p has a dividend cover of 2. As a rule of thumb, if the cover is 1.8 or more, and the company's profits are stable, the dividend is relatively safe. - A gross dividend yield significantly above the long term government bond yield
Government bonds are secure investments. There is effectively total security that income will be paid at the advertised rate until the bond matures. A share is less secure. The dividend could be reduced without warning. So, if you are buying a share solely on the basis of its income, you should look for a share with a yield that compensates for this extra uncertainty. - Stable past profits, and no sharp reduction in profits expected in the future
If profits have been volatile in the past, or if you know they're likely to drop in the future, the dividend might be cut. - A sizeable market capitalisation and a well-known name
Big well known companies are less likely to reduce their dividends, because of the adverse publicity it generates. However, this is not a cast-iron guarantee, as the examples of many large UK companies attests.
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