The Dangers of Investing Solely Based on Dividend Yield

Dividend investing is a popular strategy among investors in Singapore, particularly for those seeking a steady income stream, me included.  However, focusing solely on high dividend yields can lead to poor investment outcomes.  In this post, I shall remind myself why solely focusing on chasing high dividend yields without other considerations and analyses can be risky, and highlight some examples of Singapore-listed stocks that once paid high dividends but consequently experienced declining share prices, resulting in a non-favourable investment.

For a start, it will be good to understand that dividend yield is calculated as such:

Therefore, a high dividend yield can be a result of high annual dividends per share, or low current share price, or both.  To me, a high dividend yield is anything above 8%.  Kindly note that this yield is just a number that I generated randomly since I started investing (I do not have any financial rationale or formula to generate this yield).  I usually only look at dividend-paying companies that pay a consistent dividend yield of between 3.5% to 7.5% maximum, which I think is a comfortable yield that fundamentally sound companies can generate.

As such, does a high dividend yield necessarily signal a red flag?  From the big picture, I do not think so, because I think investors would need to understand both the underlying business and the macro-economic environment to know what causes the yield to be high.  Based on what I know and read, Singapore investor and blogger AK71 had invested heavily in a couple of REITs during the financial crisis when some of their yields were more than 10%, and the following years had proven that his actions had successfully reaped bountiful harvest for his investing journey.  Therefore this shows that high dividend yield itself is not a factor to cause one to shun away from certain investment, as long as companies remain fundamentally sound.  However, personally I am not too comfortable investing in dividend-paying stocks with very high dividend yield, because I am not very good at reading and analyzing earning reports to spot any potential red flags.  However, based on my limited experience, limited knowledge and what I saw, high-dividend yield, especially in current macroeconomic climate, is usually the outcome of the following factors:

1)     Dividend Traps

High yields often indicate that the stock price has fallen significantly.  This could be due to fundamental issues within the company, be it declining revenue, increased debt or sector-specific challenges.  If the underlying issues within the company remains unknown and investors just inject capital for the sake of dividends, the declining share price can erode any benefits from the high dividends collected.

2)     Unsustainable Payouts

Companies offering high yields, especially those that have unsustainable payout ratios which are paying out more than they earn, are basically signs of future trouble.  

To highlight what I have personally heard or experienced, below are some Singapore-listed stocks/ REITs/ business trusts that have historically offered high dividend yields but faced significant challenges at different times:

1)     First Ship Lease Trust (SGX: D8DU) (I used to own this)

The shipping industry has faced challenges such as an oversupply of ships and declining charter rates.  These adverse market conditions have negatively impacted the revenue and profitability of shipping companies, including First Ship Lease Trust, thereby affecting their stock performance.  

2)     Singapore Press Holdings Limited (SPH) (My dad used to own this)

Before its delisting, SPH offered high dividends but struggled with declining revenue from its media business and asset impairments.  These issues led to a prolonged decline in its share price.

3)     First REIT (SGX: AW9U) (Thankfully I chose ParkwayLife REIT over this)

Once known for its high yield, the trust suffered from a combination of tenant risks and a significant restructuring of lease terms.  Share prices dropped sharply during the restructuring phase, eroding investor confidence.

4)     Manulife US REIT (SGX: BTOU) (I was tempted to invest solely due to their sponsor)

In July 2023, Manulife US REIT's property valuations declined significantly, leading to a breach of its financial covenants.  This breach granted banks the right to demand immediate repayment of approximately US$1.02 billion in loans, potentially necessitating the liquidation of assets at distressed prices.  Amid these financial challenges, MUST announced the suspension of distributions to unitholders until December 31, 2025.  This move aimed to conserve cash but further eroded investor confidence.

5)     Hutchison Port Holdings Trust (SGX: NS8U)

This high-yield stock was hit by declining port throughput and headwinds in the shipping industry.  Weak earnings and high debt levels contributed to a downward spiral in its share price.

6)     Eagle Hospitality Trust (SGX: LIW)

The hospitality trust offered high yields but collapsed in a short time after listing due to governance issues and financial mismanagement.  Investors faced heavy losses as the trust was suspended.

So as a die-hard fan of dividend investing myself, how can I constantly remind myself to avoid dividend traps in my investment journey?

1)     Analyze The Payout Ratio 

Ensure that the company’s dividend payouts are sustainable.  Any payout ratio exceeding 100% is definitely a red flag and I would avoid at all cost, regardless of the reasons behind the payout.  For instance, recently I would like to initiate a position in QAF, however its payout ratio of above 100% is holding me back.  As of now, the company's metrics remain healthy with no debt, and its cashflow is definitely able to sustain the dividend payment in the short term, but that creates uncertainty for myself moving forward.  In the end, I decided to give it a miss.

2)     Examine Financial Health Of The Company/ REIT/ Trust

Scrutinize the company’s balance sheet, debt levels, and cash flow to determine its financial stability.  Constant declining operating income year after year may be an indicative signal to look out for.  Sad to say, 3 of the REITs that I am currently holding on to may reflect these signs.  I had trimmed down my positions in these 3 REITs, and I hope that turnaround may occur in time to come.

3)     Understand The Business Model

Invest in companies with resilient business models and competitive advantages.  2 of the best investments I currently hold (besides the banks) are Singapore Technologies Engineering (STE) and ParkwayLife REIT (PWLR), and both companies now have a dividend yield of below 4%.  However, with sustainable business models with a good moat and certainty, their low yields are evidences of their good performance.

4)     Diversify Your Portfolio

Avoid concentrating too much on a single stock or sector.  Spread out the investments across sectors and industries.  After the most recent rebalancing of my portfolio, I am currently comfortable with the allocations to the various sectors, where I continue to seek stable dividend income.

5)     Focus On Total Return

Consider both dividend yield and capital appreciation potential when evaluating stocks, and never solely on dividend yield.  Currently, the 3 Singapore banks are definitely churning in good returns both on the dividend front and capital appreciation.

6)     Monitor Macro Trends

Stay informed about industry-specific and macroeconomic factors that could impact the company’s performance.  Currently high interest rate environment favours the banks and not the REITs, thus it is expected for the REITs to underperform the banks under current environment.  The tide may turn one day if interest rates plunges and macro trend changes, but no one knows how events will pan out, thus it is still beneficial for me to remain invested with a diversified portfolio.

While high dividend yields can be tempting, they are not always indicative of a good investment.  REIT investors would have experienced the depressed prices in the past 5 years since covid times (for retail REITs, and past 3 years for industrial REITs).  As seen in the examples above, many high-yield stocks have suffered from declining share prices due to underlying business challenges.  By focusing on the sustainability of dividends and the overall health of a company, dividend investors can make more informed decisions and avoid dividend traps.  Always remember, a balanced approach that considers both income and potential capital growth is key to long-term success.