Our Top Pick & 3 Warnings For High Yield Investors

High Yield investing can be very rewarding if you know what you are doing. After all, in an age where cap rates on rental properties are compressing to historic lows, interest rates remain stuck near historic lows, and tech stocks like those found in ARK Invest’s flagship ETF ARKK have proven to be excessively volatile and unreliable, if you can lock in a reliable high single-digit yield, you will probably sleep better at night while also beating the S&P 500 (SPY) over the long-term.

Fortunately for us, we have been able to execute this dream scenario thus far at High Yield Investor. By being highly selective and pursuing tactical diversification into high yield investments, we have been able to combine strong and safe weighted average income yields (5%-6%) with strong market outperformance for our portfolios:

However, it is important to keep in mind successful High Yield investing is very difficult, and it is much easier to achieve substantial losses if you make a few key mistakes. In this article, we present the most common mistakes made by high yield investors and also highlight our top pick of the moment.

#1. There Is No Such Thing As A Free Lunch

There is no such thing as a perfectly safe high yield. The market may overreact from time to time and therefore behave irrationally, but it is ultimately not stupid. If a stock offers a high single digit to low double digit yield, it is very likely that it comes with considerable risk to the dividend, if not the balance sheet as well.

If you do not see anything wrong with the balance sheet or business, or at the very least if you think the dividend is perfectly safe, you need to look again. High yield investing is all about risk mitigation, and the first step of mitigating risks is thoroughly understanding the risks. That is why in our in-depth research reports for all of our investments at High Yield Investor, we include a section titled: “Why Mr. Market Does Not Like It.”

Once we feel we have a thorough understanding of why the stock is offering a high yield in the first place, we can then make an educated decision of whether or not we are taking on more risk than we can chew, or if it truly offers an attractive risk-adjusted yield and total return potential.

Additionally, by understanding the risks at play, we are also able to better allocate our additional investments in order to achieve proper diversification.

For example, midstream businesses like Enterprise Products Partners (EPD), Energy Transfer (ET), and Enbridge (ENB) offer very juicy income yields and also sport stable cash flowing business models and investment grade balance sheets. What could possibly go wrong with these investments?

Well, there is considerable debate about the longevity of current demand levels for the fossil fuel industry and its associated infrastructure. As a result, Mr. Market has gotten increasingly skittish about owning fossil fuel related investments. Furthermore, the ESG investing movement has driven a lot of capital out of the sector in favor of high yielding opportunities in renewable infrastructure such as Clearway Energy (CWEN.A) (CWEN), Atlantica Sustainable Infrastructure (AY), and Brookfield Renewable Partners (BEP) (BEPC).

While we are very bullish on the midstream sector despite these risks and headwinds, we still diversify into other portfolios, realizing that our knowledge is not infinite and that Mr. Market could end up being proven correct in this case.

#2. Payout Ratios Are Not As Important As Balance Sheet Strength

One of the biggest mistakes that we see with high yield investors is an obsessive focus on payout ratios while not taking an equally strong look at the state of the balance sheet. While a dividend that is not covered by cash flows – and unlikely to see its coverage ratio improve anytime soon – is probably not sustainable, neither is a dividend that has very healthy free cash flow coverage, but is backed by an overleveraged balance sheet that puts the company’s health, or at the very least its investment grade credit rating, at risk.

For example, over and over again, we heard that AT&T’s (T) dividend was safe. After all, it had grown the dividend every year for decades and had strong free cash flow coverage of the dividend. However, this was not the full story. As we cautioned in an article on May 6th, 2021:

the dividend is not nearly as safe as the 65% payout ratio implies. In fact, ~98% of revenue is currently being consumed by expenses and the dividend, giving management a mere ~2% cushion to continue covering its dividend.

Furthermore, inflation is surging, meaning that there will continue to be upward pressure on interest rates. With such a massive debt burden, if interest rates rise materially for an extended period of time, T will quickly see its dividend coverage erode as more and more cash flow is consumed by increased interest costs. As a result, management will be forced to shift priorities from supporting a large and burdensome dividend to diverting as much cash as possible towards paying down debt.

Last, but not least, T’s forays into streaming and fiber – while filled with growth potential – are also very capital-intensive. T will have to spend a lot of money to generate sufficient content to compete with the likes of Netflix (NFLX), Amazon (AMZN), Disney (DIS), and Apple (AAPL) in streaming wars and fiber infrastructure is very expensive to build out and faces limited barriers to entry. As a result of these capital demands, one or both of these business ventures may eventually push T to slash its dividend.

Sure enough, less than two weeks later, T announced that it would be cutting its dividend, leaving high yield investors burned.

#3. Better To Sacrifice Some Current Yield In Exchange For Some Safety & Growth

Instead of chasing yield and simply investing in the highest yielding stocks at the moment, investors are typically better suited being patient and prudent by combining growth, safety, and yield in their investing pursuits.

Yes, investing in high yield dividend stocks has its perks, and we ourselves invest a large percentage of our net worth into high yield stocks (DIV), utilities (XLU), MLPs (AMLP), and REITs (VNQ). In addition to the psychological benefits and financial security provided by a steady stream of cash flow instead of being dependent on the market’s ever-changing whims, by forcing management teams to pay out a sizable percentage of cash flows to shareholders, they have to be very disciplined with capital allocation and therefore tend to generate stronger returns for shareholders over the long-term.

However, starving a business of its capital can also be a major problem. By paying out too high a percentage of cash flows as dividends, companies often become too dependent on equity and debt markets to raise the capital they need to sustain and grow the business and end up diluting shareholders and/or overleveraging the balance sheet. Worse still, they may skimp on improving the business and eventually surrender their competitive positioning to others in their industry who – instead of paying out excessively high dividends – invest aggressively in their businesses in order to beat the competition over the long-term.

A classic example of this is seen in the net lease space. Global Net Lease (GNL) lures investors in with its mouthwatering double-digit dividend yield. However, it has cut its dividend numerous times in the past and has been crushed over the long-term by peers like Realty Income (O) and STORE Capital (STOR), who have blended attractive mid-single digit dividend yields with intelligent reinvestment in their businesses to grow their portfolio, secure strong investment grade credit ratings, and ultimately continue to grow their dividends at sustainable rates.

Top High Yield Pick Of The Moment

Given our view that tens of trillions of dollars of capital will flow to real assets like infrastructure over the next decade, we think that alternative asset managers are an attractive investment right now. In particular, we like Brookfield Asset Management (BAM), Blackstone (BX), KKR (KKR), Ares Management (ARES), and The Carlyle Group (CG) as they all have proven track records of crushing the market, a deep bench of leading global clients, and impressive growth runways.

However, there is a little known alternative asset manager that trades at the cheapest valuation and also offers by far the highest dividend yield and arguably the most impressive growth runway of the bunch: Patria Investments (PAX). After partnering with BX for years to build out an impressive global fundraising platform and establishing itself as the Blackstone of Latin America, it is expecting to grow its earnings and dividend per share at a rapid clip in the years to come. Latin America is a highly fragmented and underpenetrated alternative asset management market, and PAX has established itself as the undisputed early leader in the space. It went public last year in order to raise capital to enable it to move to acquire other major players in the region to further bolster its competitive advantage.

Meanwhile, it trades at a steep discount to larger global alternative asset managers and offers a dividend yield of nearly 6% while expecting to grow distributable earnings at double digits annually moving forward. Its balance sheet is debt-free and the company has a multi-decade track record of generating outstanding returns for clients in its investment funds. We recently did a deep dive interview with the company and gleaned a lot of very interesting insights about the investment thesis.

Investor Takeaway

High Yield investors love to lock in lucrative income streams, and there is certainly nothing wrong with that approach to investing. In fact, we do it ourselves. As legendary billionaire businessman and investor John D. Rockefeller said:

Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.

However, before diving headlong after the highest yielding stocks of the moment or recklessly going all-in on a “can’t miss” high yield bet, we believe it is more prudent to first take a step back and look at the reason why the stock offers an attractive yield, take a hard look at the balance sheet strength, and ideally focus on businesses that are still able to generate some growth alongside paying out a massive dividend.

By taking this highly selective approach, we end up investing primarily in 4-7% yielding companies in today’s market:

We believe this is largely why we have been able to successfully and consistently outperform the market.