Income Investing Takes Homework, Too

By Sharon Fay February 16, 2012

Equity-income investing can be highly rewarding, but it is not without its potential pitfalls. The rules of careful stock-picking still apply.

Stocks that generate high income offer investors a welcome refuge in today’s stormy markets because they have the potential to preserve capital and to deliver at least some positive return. For many investors, a strategy that emphasizes such stocks beats trying to time the market’s low or dealing with stressful market swings.

But even in this relatively safe corner of the investment world, it’s still important to do your homework. Investing solely for the highest dividend yield or the biggest buyback program can backfire, sometimes badly. An unusually high dividend yield is often a sign of a company in trouble, and can presage a dividend cut.

Research conducted by my colleague John Phillips found that the quintile of global stocks that pays the highest dividend yields has outpaced the market since 1971—but the next-best quintile did even better (Display), and with materially less volatility. Why? There are generally fewer blowups in the second quintile than in the first.

Highest Yielding Stocks Aren't the Best Performing Buybacks also have a strong history of rewarding shareholders. Since 1971, the quintile with the least net equity issuance (an indicator that a company is either buying back shares or issuing relatively few new ones) has strongly outperformed both the market and all other quintiles (Display). But companies that repurchase shares at prices above the fundamental value of their assets destroy value for shareholders—especially if they finance buybacks by taking on excessive debt.

Shareholder-Friendly Companies Are Best This research suggests that it pays to study each company’s cash-returning potential on its own merits. You must analyze the sustainability of each company’s cash flows within the context of its business outlook, long-term capital reinvestment needs and debt burden.  

The popularity of equity income strategies over the past two years has pushed up valuations, but I still see substantial opportunity in these strategies. Corporate cash levels are still near all-time highs, and net debt is lower than at any time since the early 1980s. Yet buybacks and dividend payouts are still in the doldrums. In the US, dividend payouts are at an all-time low. But the pressure on companies to increase their cash giving continues to build, especially with short-term interest rates likely to stay near zero for some time.

Investors have paid the most for firms with the highest current dividend payouts—notably utilities, which posted the strongest total return gains of any US sector last year. But investors have been hesitant to do so for firms that have the capacity to be much more generous in the future. That’s why we’ve explicitly targeted our research to those cases where strong cash-return upside potential and attractive valuations intersect. We continue to take advantage of these opportunities across diverse sectors, such as technology, consumer cyclicals, materials and energy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Income Investing Takes Homework, Too
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