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Be wary of extreme yields

The urge to reach for yield can be hard to resist. But income investors should be wary of securities with extraordinarily high yields because they're often accompanied by similarly large risks.

I like Canadian dividend stocks with reasonable yields, which is why I'm a fan of Scott Barlow's list of dividend-paying stocks in the S&P/TSX Composite Index. It's easy to start at the top of the list and imagine enjoying yields north of 7 per cent for many years to come.

Before exploring whether high yields lead to happy returns, it's useful to look at how the S&P/TSX Composite, a fair proxy for the Canadian market, has fared over the years. The index enjoyed average annual returns of 7.4 per cent over the 21 years from the end of 2001 through to the end of 2022.

Similarly, an equally-weighted portfolio of all the businesses in the index climbed by an average of 7.2 per cent annually over the same period when rebalanced each year. (All of the portfolios herein are equally weighted and rebalanced annually. Their returns are based on data from Bloomberg and include dividend reinvestment, but not fund fees, commissions or other trading frictions.)

Income investors love their dividends and a portfolio containing only the dividend-paying stocks (and trusts) in the index climbed by an average of 9.1 per cent annually from the end of 2001 to the end of 2022. The dividend payers, as a group, enjoyed above-average returns over the period.

I sorted the index's dividend payers into percentiles by indicated yield. Think of percentiles as grades that go from 0 for the stock (or trust) with the lowest yield to 100 for the one with the highest yield.

The dividend payers are then put into five portfolios based on yield. The portfolios each contain as close to an equal number of constituents as possible. The portfolio of dividend payers with the second-highest yields (those from the 60th to 80th percentiles) fared the best, with average annual gains of 10.2 per cent from the end of 2001 to the end of 2022.

Reaching for yield in the S&P/TSX Composite Index

The first four portfolios (below the 80th yield percentile) outperformed the index over the period as shown in the accompanying chart. The worst performer was the portfolio containing the fifth of businesses with the highest yields, which isn't shown in the chart. It gained 7.2 per cent annually over the period and slightly lagged the returns of the index.

Intrigued, I cut the highest-yield portfolio (above the 80th percentile) in half by yield. The highest-yielding half (more than the 90th percentile) gained an average of 4.4 per cent annually from the end of 2001 to the end of 2022. The lower-yielding half (80th to 90th percentile) fared much better, with average annual gains of 9.8 per cent.

I repeated the process by splitting the highest yield half in half yet again. The portfolio with the 5 per cent of businesses with the very highest yields gained an average of just 0.4 per cent annually. Gulp! (To make it into the extremely high yield group, a stock currently has to pay a dividend yield north of about 7 per cent.)

On the other hand, the group with the next-highest 5 per cent of yields gained an average of 7.4 per cent annually, which happens to also be the return generated by the S&P/TSX Composite Index as a whole.

Overall, returns tend to fall dramatically when yields reach extremely high levels.

It's fairly easy to explain why stocks with giant yields might perform poorly. Just think about how a stock gets a high yield. In happy cases, yields are boosted by dividend growth. But extremely high yields often occur when a business falters and its share price falls dramatically. In such cases, the low price and high yield reflect the risk of an impending dividend cut - or worse.

However, very high yields do not always lead to poor returns. Sometimes the market becomes overly pessimistic, and the stock proves to be a bargain over the long term. When seeking dividend stocks, I tend to favour those with the generous yields from the 60th to 90th percentiles, which currently corresponds to yields between roughly 3.8 per cent and 6.1 per cent.

After all, history shows that investors should think twice before reaching for stocks with extremely high yields.

First published in the Globe and Mail, January 15 2023.

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