Buying for bumper dividends is a risky game to play

Like many statistics in the world of finance, dividend yields are useful but also have the potential to be extremely misleading.

It would be wonderful if we could simply take the firms with the best yields, dump all our money into their shares, and then wait for a big payout.

Unfortunately things aren’t that simple. In fact, an abnormally high yield is normally seen as a bad sign by investors.

High dividend yields can be a warning sign

The reason for that is a high yield can often be the result of a declining share price. 

Yields are typically calculated by adding up the dividends a firm has paid out over the past 12 months and then working out what they are as a percentage of the current share price.

So if you had a firm with shares worth £1 each and it had paid out £0.10 over the past year, it would have a 10% yield.

But if the same firm saw its share price fall to £0.50, its yield would suddenly rise to 20%.

A 20% yield sounds great superficially, but a firm that has lost half its value probably has some major problems that would make actually paying that dividend tricky.

One way to check how viable future payouts are is to look at a company’s dividend cover. This compares a firm’s profitability with its dividend payouts. 

There is no cut and dry rule here but a dividend cover that’s less than 1.5 is often considered a sign that future payouts could be at risk. 

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Evraz may buck the high yield trend, but should you buy?

The company with the largest yield on the London markets today may not actually fit within this dynamic though.

Mining and steel production company Evraz has seen its share price rise by almost 70% over the past year, admittedly with some dips and dives along the way.

Its current yield sits at a hefty 13.5%. The firm has benefitted from a rise in steel prices over the past 12 months, with its $1.2bn net profit for the first half of this year higher than the $848m it made in the whole of 2020.

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Cost cutting has also had an impact. Evraz said in August that “productivity improvement initiatives” had boosted operating profit by $256m.

Part of the reason the firm has such a hefty yield is that it tends to pay out almost all of its free cash flow to shareholders.

For instance, free cash flow for the first half of this year was $836m and the total value of the dividends paid was $802m.

Remember, investments and the income you receive from them can go down as well as up and you might get back less than you invest.

Evraz’s high dividend yield may not last

The question for investors is whether these sorts of bumper results will continue, at least into the near future, so the firm can pay out large dividends.

The positive side is that steel prices remain high. Coal markets, Evraz’s other big source of revenue, are also booming at the moment. Incidentally, higher commodities prices are behind some of the other high yielding UK stocks at the moment, like BHP and Rio Tinto.

Predicting how long this boom will last is a tricky business though. Steel prices were last at these sorts of levels a decade ago and promptly plummeted. Evraz subsequently paid only one dividend in a five-year period, before prices started to rise again in 2017.

Another curious part of Evraz’s business is its exposure to massive currency risk. Most businesses have this problem but it tends to have a fairly mild impact on their overall profitability.

Contrast that with the steelmaker, which saw a $408m currency gain in 2020 and a $341m loss in 2019 purely because of currency fluctuations. 

That suggests their impact could smooth out over time but, for someone looking for a large dividend yield, it could easily take a big hit if the foreign exchange markets move against Evraz.

Investing in high dividend yields can be high risk

All of this makes pinning your hopes on a 13.5% return a risky game to play. 

Evraz has done a good job of paying out the money it makes to shareholders in recent years.

The trouble is the firm’s cash flows are largely determined by market forces which are out of its control, making it very hard to say if they’ll continue at the sort of levels we’ve seen in the past 12 months.

At the same time, currency fluctuations have historically been a huge hit or miss for the firm, putting those dividends at risk even if the commodities markets work in the company’s favour.

An analysis of this sort is also extremely narrow in scope. We’re basically looking at how sustainable Evraz’s dividend is for the very near future.

The trouble with doing this is it says nothing about the company’s long-term performance. 

Maybe you could buy now and get a great dividend yield as a result. But if the firm’s share price came crashing down shortly afterwards then any celebrations would be short-lived. 

Similarly, a firm may realise it simply can’t pay the large dividends investors want and cut back, or even scrap, the payments.

That’s why simply buying in the hopes you’ll get a large yield is usually a bad idea. 

Like any other statistic, a dividend yield is one piece of a large puzzle that a company is made up of. Buying on that basis means you miss the whole picture and leave yourself liable to a greater loss than you might achieve from any short-term yield.

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What's your take on Evraz? Let us know on the community forum:

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Past performance is not a reliable indicator of future returns. Source: FE, as at 28th Sept 2021. Basis: bid-bid in local currency terms with income reinvested.

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