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Course 407
High-Yield Stocks

Introduction

High-yield stocks are like the little engine that could. With dividend yields that are at least twice that of the large-cap average, these stocks are a far cry from capital-gains-charged growth companies. Instead, by paying a solid dividend year in and year out--and with a little push from the power of compounding--these stocks can add incrementally to performance, eventually piling up a mountain of returns. There are reasons besides income to hold these stocks. For one, they generally have low valuations, largely because price appreciation and yield are inversely correlated: If a stock's price rises, its yield falls. Their relative cheapness can make high-yield stocks defensive plays during a bear market, lowering the overall volatility of a diversified portfolio. In the last three months of 1987, when the S&P 500 suddenly lost one fourth of its value, the S&P Utility index--a proxy for high-yield stocks--was a relative haven, falling only half as much. High-yield stocks don't offer much in the way of growth, though. These companies have made a choice to pay out a good portion of their profits as dividends rather than plow the money back into expansion. As of the end of 1999, the high-yield companies in Morningstar's database had an average EPS (earnings per share) growth rate of 7% over the previous three years, about half the growth rate for the S&P 500. Tobacco and food conglomerate Philip Morris MO is a good example of a high-yield stock. Its dividend yield of nearly 7% (as of late 1999) is in the top quarter of all the stocks in the high-yield stock type, and its revenue and earnings growth have been slow but relatively steady. After several years of healthy gains, Philip Morris' stock has recently stumbled because of fears about the cost of tobacco litigation. The following are some questions that are worth asking about high-yield stocks in general, with answers as they apply to Philip Morris in particular.

What Is the Company's Dividend Track Record?

Since dividend yield is the ratio of a stock's dividend to its price, it is possible for a stock to suddenly become a high-yield stock just because its price has dropped. And there is likely a good reason. The firm could be in a cash crunch, or its market could be shrinking. If so, it is a good bet that the dividend checks won't be as fat in the future. The trick is to find a stock that has a high yield because its dividend is high and steady--or rising--and not because its price has weakened. Philip Morris fits the bill. Its dividends per share rose at an average annual rate of 11% per year between 1996 and 1999, and the rise was steady, with gains in every year. Even when its earnings fell in 1998, Philip Morris still raised its dividend.

Is the Payout Ratio Rising?

The payout ratio, which shows dividends as a percentage of earnings, is a key indicator of a company's ability to maintain its dividend. A high payout ratio--one that's more than 70%, for example--is normal for a high-yield company, but one that is rising could be a problem. An increasing payout means that unless the firm can boost earnings, dividends will eventually hit a ceiling or even decline. Philip Morris' payout ratio has been relatively stable, staying above 50% over the past five years. In 1998, however, it spiked upward above 70% as the company's earnings dipped. Such spikes can be a cause for concern if the ratio remains high, but Philip Morris' payout ratio has since returned to its normal level.

Are the Company's Sales and Earnings in Line and Stable?

Consistent earnings power is the key to maintaining a dividend. In order to pay a plump dividend year after year, a firm needs a business that generates a reliable stream of cash. Earnings alone might not show the whole picture, though. It is possible to keep earnings steady despite weakening revenues, just by cutting costs. But eventually, such a company in a declining market will exhaust the possibilities for cost-cutting, and earnings will fall. Philip Morris has been a slow but consistent grower in recent years, with revenue inching up 3% per year. Earnings, for the most part, have been consistent, as well. The only recent exception has been in 1998, when earnings dipped 15% year-on-year, which explains the spike in the payout ratio: Philip Morris maintained its dividend even though earnings softened. One major potential threat to the company's earnings, though, is tobacco lawsuits. That's why it's important to consider Philip Morris' cash flow.

Does the Company Generate Consistent Free Cash Flow?

Noncash charges, such as depreciation and amortization, can sometimes cause a company's earnings to dip and its payout ratio to spike. A high payout ratio under such circumstances isn't necessarily a warning sign of an imminent dividend cut. That's why it's important to look at the company's free cash flow. Free cash flow represents the cash a company generates from its operations, net of what it spends on its plant and equipment. These are the funds a company can use to pay dividends, among other things. If free cash flow is strong, dividend payments probably won't be a problem for the company, even if earnings stumble in that year. Philip Morris' free cash flow more than covered dividend payments in 1999. In fact, its free cash flow of $9.6 billion was more than twice what it paid out in dividends, leaving a few billion dollars extra for such possible expenses as lawsuit settlements.

Is the Balance Sheet Healthy?

Unlike growth-type companies, high-yield companies don't have to be able to fund a lot of expansion. Still, they need to have finances that are at least healthy enough to support their businesses. Too much debt, for example, can soak up cash flow and reduce a company's options for further financing. Philip Morris' long-term debt appears to be manageable. Its debt-to-equity ratio of 0.7 at the end of 1999, while higher than the high-yield average, was still lower than that of rival tobacco giant RJ Reynolds RJR. The huge amounts of cash Philip Morris generates make a little extra debt much more palatable. It's also sitting on $5 billion in cash, or about 8% of its total assets.

How Has the Stock Performed?

High-yield stocks occupy a unique niche in the stock world: one where capital appreciation isn't the prime concern of many of the investors who buy them. The tradeoff for a high-yield stock is that you get the relative safety of a predictable income stream by passing up less certain, but possibly more rewarding, capital gains. Stability is one of the key advantages to high-yield stocks. Investors may not reap stellar capital gains, but downside risk is limited as well. Philip Morris hasn't quite fit this mold. From 1995 through 1997, it delivered 30% annual capital gains on top of its 4% yield, making its investors very happy. Since the beginning of 1998, though, the stock has been on something of a roller-coaster ride as the market reacted to a series of tobacco lawsuits: It sank during the first half of 1998, rose during the second half, then shed more than 50% of its value in 1999 after losing several court cases. The stability normally associated with high-yield stocks hasn't been there for Philip Morris.

Is This Stock Expensive Relative to Others in Its Industry?

Philip Morris is cheap by just about any measure, especially compared to other large-cap stocks. Its P/E (price/earnings) of 9 at the end of 1999 was less than a quarter the S&P 500's, and its price/sales and price/cash-flow ratios were similarly low. The main reason for this, of course, is the tobacco business, and the market's jitters about possible liability payouts eating into future earnings. Few companies are better prepared for such an eventuality, though. The $6 billion in cash Philip Morris generates each year is enough to pay for hundreds of lawsuits.

Conclusion: Looking Both Ways

Philip Morris' business has historically been stable enough for the company to pay out a consistently plump dividend. Its sales and earnings have been fairly steady, and even when earnings declined in 1998, the dividend still rose. It has a manageable amount of debt and generates huge amounts of cash, much of which it uses to pay out dividends, and the rest of which it stashes away for contingencies. The one major risk factor is the tobacco litigation issue, which has made Philip Morris more volatile than the typical high-yield stock and driven its price down. But this volatility has been cushioned by the company's consistent and juicy dividend, which is not likely to be cut even in a doomsday litigation scenario. Despite the bumpy ride its stock price has taken, Philip Morris has done very well what a high-yield stock should do: provide a consistent stream of income to its shareholders.

Quiz 407
There is only one correct answer to each question.

1 When a stock's price increases, the yield typically:
a. Increases.
b. Decreases.
c. Remains constant.
2 High-yield companies typically exhibit:
a. Faster than average growth.
b. Slower than average growth.
c. Average growth.
3 Why might a rising payout ratio (the percentage of earnings that is returned to shareholders as dividends) be a concern?
a. Over the long term, deteriorating earnings may force a company to cut its dividends.
b. A company's payout ratio should never be higher than its dividend yield.
c. Rising dividends are usually a sign that growth is slowing.
4 A key benefit of a high-yield stock is:
a. Above-average growth.
b. Above-average P/E ratios.
c. Stable dividends.
5 Which factor is most important with regard to a company's ability to pay dividends?
a. Revenues.
b. Earnings.
c. Free cash flow.
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