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Tim Meador
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I work as a credit analyst and trade infrequently. I invest in companies with competent management and strong returns on capital trading at attractive valuations.
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  • Avoiding The High Yield Trap

    Last week I had frustrating conversation with a friend that went something like this:

    Friend: I found a stock that has a 9% dividend.

    Me: What else do you know about the company?

    Friend, shrugging: It has a 9% dividend.

    With interest rates being held artificially low by the Fed, many otherwise conservative investors and retirees have gone hunting for yield among the forest of stocks, MLPs, preferred shares and royalty trusts. The dividends and distributions of many of these securities are well supported by a strong foundation of free cash flow, while others are held aloft by literally nothing. The latter are destined to come crashing down to earth, taking with them the hard earned money of their shareholders. Avoiding this high yield trap requires a simple understanding of where dividends come from, namely free cash flow and capital allocation.

    A common failure of the casual investor is the tendency to hone in on the result of capital allocation (the dividend) instead of the source of distributable capital (free cash flow). Free cash flow is what remains after paying taxes and making capital expenditures that are required to sustain business operations. Management can do five things with this left over cash:

    1.) Keep it as cash

    2.) Pay down debt

    3.) Grow the business, either through acquisitions or organic investment

    4.) Buy the company's shares on the open market

    5.) Return the cash to shareholders via a dividend

    Do not assume that returning cash to shareholders is the best use of free cash flow. Prudent management will allocate free cash flow to areas with the greatest return for shareholders, which often means reinvesting in the business. Retaining free cash flow as cash or using it to repay debt can serve to improve the balance sheet. Companies that fail to maintain a strong, liquid balance sheet will find themselves at the mercy of the business cycle.

    Share repurchases or dividends should be considered only after the balance sheet is addressed and investments in the business are made. Share repurchases have the advantage of avoiding the double taxation of dividends and decrease the number of pieces in the company pie. They can also be one of the greatest tools of value destruction when purchases are made at prices that exceed intrinsic value. Take Dell as an example. From 2005 to 2012, Dell's management spent over $24B purchasing Dell stock at an average price of more than $24 per share. Dell's market cap on 11/02/12 was $15.87B, meaning Dell spent $8B more buying back shares than the company is currently worth.

    Returning cash to shareholders via dividends reduces the tendency of management to destroy shareholder value by placing the burden of capital allocation on the shareholders. The problem with dividends is when they are deemed essential by investors, to be maintained or increased at all costs. Management can be incentivized to prioritize paying dividends over more prudent uses of capital, sometimes resulting in declining operations, worsening balance sheets and ultimately, the failure of the business. Investors seeking yield should focus first on the company's competitive position, free cash flow and balance sheet before looking at dividend yield. As David Merkel put it so well in this article,

    "Most people think of yield as a magic chicken that lays eggs on schedule and never gets sick or dies. Those who truly understand markets know that yield is an allocation of free cash flow and that many businesses can't control their free cash flow, so dividends are less than fully certain."

    There are no magic chickens or guaranteed dividends. Take the time to examine the ability of a business to sustain its dividend before investing. Doing so will help you avoid violating the first rule of investing: Don't lose money.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Dec 13 8:22 PM | Link | Comment!
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