AQNB - What I Wish I Knew Before Buying High Yield Stocks

2023-08-14 13:46:42 ET

Summary

• High yield stocks are attractively priced due to rising interest rates and macroeconomic headwinds.
• My high yield investing strategy has delivered very strong returns over the long term.
• However, high yield investing can also be extremely hazardous to one's wealth if not done properly.
• I share some of my most important lessons learned.

Thanks to the rapid rise of interest rates over the past year and a half, alongside geopolitical, inflationary, and other macroeconomic headwinds, high yield stocks have rarely been more attractively priced than they are today. Just take a look at what some of the leading blue chip high yield stocks are offering right now:

• The leading midstream ( AMLP ) blue chip - Enterprise Products Partners ( EPD ) - offers investors an extremely safe 7.54% distribution yield that is growing at a ~5% CAGR.
• The leading REIT ( VNQ ) blue chip - Realty Income ( O ) - offers investors arguably the most dependable monthly dividend in the stock market at a current 5.2% yield and a mid-single digit CAGR going on over a quarter of a century.
• The leading BDC ( BIZD ) blue chip - Ares Capital Corp ( ARCC ) - offers investors a well-covered 9.8% dividend yield that is often supplemented with special dividends on top of it.

Clearly, there is an attractive combination of value and quality available in the high yield space. That said, the sector is far from a guaranteed ticket to financial independence and riches. For every high quality and sustainable high yield stock out there, there are many more that are ticking time bombs. As a result, while high yield investing can certainly be a very lucrative and rewarding approach to investing, it a requires knowledgeable, prudent approach to avoid suffering large long-term losses.

Here are two lessons that I wish I had learned before investing in high yielding stocks:

#1. Blindly Trusting Management Teams

Many times, management teams will make rosy projections about their company's ability to deliver strong long-term growth alongside paying out a very attractive dividend. While management does (hopefully) have the clearest view of the performance of and outlook for their business, they do not always share an honest assessment of the true state of their business. Sometimes, they may even be giving their best assessment, but they lack the foresight to properly understand the macroeconomic and/or competitive threats coming their way.

Two classic examples of this from my own experience were Algonquin Power & Utilities ( AQN ) and Lumen Technologies ( LUMN ).

AQN had a very impressive history of delivering a consistent ~10% dividend per share CAGR over the course of about a decade. The company had a robust growth pipeline fueled by a powerful one-two punch of its renewables business segment and its regulated utilities business segment. Moreover, it had an investment grade balance sheet and the dividend yield looked quite attractive at over 5% following a pullback in the stock price. With management continuing to guide for robust dividend growth in the years to come, I bought shares, taking management at its word.

However, if I had taken more care to look under the hood, I would have seen that they actually had considerable exposure to floating interest rates and were taking on a lot of leverage to finance their aggressive growth pipeline. With interest rates soaring in 2022, AQN got caught swimming naked when the tide went out (to borrow from a Warren Buffettism ). As a result, it was forced to slash its dividend and the stock price plunged, burning me and many other gullible investors who had trusted management's guidance.

Fortunately, in the case of LUMN, I sold before the massive dividend cut, but this was another case of a company that continued to speak glowingly of its strong growth potential that would be fueled by the "4th Industrial Revolution" all while also pitching its $1 per share dividend as a top capital allocation priority that would be sustained through the pivot to growth.

Once management quietly removed this priority from its slide show, I asked the company point blank about it, and they tried to talk around it. Thankfully, I sensed something was going on and sold my shares, and sure enough, shortly thereafter, management not only cut the dividend, but actually totally eliminated it. Since then, the stock has completely cratered as it has failed miserably in its efforts to pivot to growth. Sadly, investors who failed to jump ship have been burned badly as over the past year LUMN stock has lost over 84% of its value.

While management guidance and commentary can be very useful, never ever take it as gospel truth. Do your own due diligence. Ask hard questions when you get a chance to speak to a company. Oftentimes, how they answer questions on earnings calls and when you speak with them says as much, if not more, than what they actually say.

#2. Completely Ignoring Macroeconomic Factors

Another lesson I wish that I had learned before investing in high yield stocks is that it is foolish to completely ignore macroeconomic factors. Yes, I am a bottom-up investor who focuses on company-level fundamentals and valuations when making investment decisions and I generally do not make macroeconomic forecasts and therefore do not make my investment decisions based on where I think the economy is headed. However, that does not mean that I should be totally blind to what is happening in the broader economy when allocating capital.

What I mean by this is that sometimes it is clear what is going on in the broader economy and what the ramifications will be for a stock in my portfolio. Even if the stock looks deeply undervalued and likely to deliver attractive returns over the course of a full economic cycle, it may be apparent that the current economic situation will cause excessive distress for the business. As a result, market sentiment may be highly likely to remain negative on the stock for the foreseeable future and in some cases, a dividend cut may be highly likely as well, further exacerbating market sentiment.

A classic example of this was recently seen in the apparel sector. A stock that I owned was Hanesbrands ( HBI ). It had recently brought on an impressive new CEO who was previously a senior executive at Walmart ( WMT ) and was implementing an impressive plan to improve the company's brands, supply chain, and operating efficiencies. However, it quickly became apparent that a perfect storm of macro events was transpiring that were leading to an unmistakable solution. Inflation was soaring, interest rates were spiking, a prolonged imbalance in supply and demand, and an out of the blue cyber-attack on the company exacerbated its fairly heavily leveraged balance sheet and left management with little choice but to eliminate the dividend. Throughout this entire process the stock price continued to plummet, yet, given my focus on the long-term disconnect between supply and demand and principled agnostic approach to macro factors, I held the whole way down through the dividend cut. Given that I am an income investor, I ended up selling the stock after the dividend was eliminated.

In hindsight, I should have seen the writing on the wall much earlier in the process and sold the stock at a much smaller loss than I ended up doing after the dividend was eliminated. Granted, I got lucky and was able to recycle the capital into New York Community Bancorp ( NYCB ) right near its bottom during the March crash in the banking sector, leading to me gaining back much of my losses on HBI in short order. However, my handling of the HBI investment was still a clear mistake. Was my initial investment a mistake in the sense that my reasoning was wrong? I don't believe so. The fundamentals and valuation seemed to clearly indicate that HBI was undervalued, but the macroeconomic and black swan factors - which are highly unpredictable - conspired against it and sent the stock tumbling. This is just part of investing and is why I diversify my portfolio. However, my mistake was holding HBI for as long as I did despite the clear headwinds facing the stock. I should have just eaten my losses and moved on at a much earlier stage in the process.

Investor Takeaway

Now is clearly an exceptional time to invest in high yield stocks given where valuations sit. However, investors should not jump in head first into the sector recklessly. Many high yield stocks are high yield for a reason.

While I certainly value management's opinion and listen closely to the earnings calls, investor presentations, and the answers they give in my interviews with them, I have learned the hard way that just because a management team says that its high yield is "safe" does not mean that it really is.

Moreover, while I am a big believer in taking a bottom-up approach to investing and not making investment decisions based on macroeconomic forecasts, I also believe that it is foolish to completely ignore macroeconomic factors once it becomes obvious that they are going to force one of your holdings to slash its dividend and potentially even face financial distress.

By taking these lessons along with many others into account when investing in high yield stocks, investors can avoid painful dividend cuts and the steep principal losses that almost always accompany them.

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