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Dividends

David Gunn

I have cautioned on several occasions that securities that offer unusually high yields carry above-average risk. That's an axiom of the stock markets that investors have to understand.

Stocks that offer payouts of 6 per cent+ may look very attractive but they carry a lot of baggage. The company may have a history of uneven earnings, high volatility, questionable management, or a high payout ratio. It may operate in a market sector that is highly cyclical or is out of favour. The yield is a tip-off that there are probably problems lurking beneath the surface even if they are not evident at first glance.

We have recommended some high-yield stocks in my newsletters over the years but always with appropriate warnings. Some have worked out well, while in other cases the price has dropped as the risk factors kicked in.

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One big winner was Enerplus Corp., which I advised selling in February for a total return of 122.6 per cent after holding the stock for a little over one year. Another is Cargojet, which gave us a total return of 84 per cent in just five months.

Some of my other high-yield selections are in more modest profit territory. One example is Premium Brands Holding Corp. It was selected in July 2013 when it was trading at $19.49. The shares were trading recently at $21.25, so they've gained a bit of ground. I picked this stock because of the 6.4 per cent yield at the time was attractive and apparently sustainable, plus the company has an impressive growth record. But I commented that the company's policy of basing its payout ratio on free cash flow was questionable. (For corporations, I prefer to see a payout ratio based on earnings unless they have unusually high depreciation and amortization charges.)

Premium Brands shares got as high as $24.55 in late February but fell to below $21 in March and continue to trade around that level. That was partly a result of year-end earnings that disappointed investors and partly profit-taking because the stock had gotten ahead of itself.

The company released first-quarter 2014 results earlier this month. They showed a 16.4 per cent increase in revenue to $266.9-million. Free cash flow for the last four quarters was $46.9-million, compared to total dividends paid of $27.2-million, which the company says translates into a payout ratio of 58 per cent. However, real earnings were only $1.9-million. That was up about 60 per cent from the same period in 2013 but translates into only $0.09 on a per share basis. The quarterly dividend is $0.3125 so actual earnings continue to fall well short of dividends. Because the yield is now down to 5.9 per cent due to the price appreciation, I now rate PBH as a hold.

No one gets it right all the time and one of my high-yield picks that has turned sour is Canexus Corp. I recommended it in February 2013 when it was trading at $9.08 and yielding 6.06 per cent. It's now trading at $4.62, with the trailing 12-month yield up to a whopping 12 per cent.

Canexus's main business is the production of sodium chlorate and chlor-alkali products, largely for the pulp and paper and water treatment industries. The Calgary-based company owns four plants in Canada and two at one site in Brazil. In addition, the company offers oil and gas transloading services to unit train at its terminal at Bruderheim, Alberta, which is being expanded.

The stock hit a high of $9.44 in July but then started a downward trend that has continued to the present day. I don't see much hope for a turnaround any time soon. This month, the company announced first-quarter results, which showed a year-over-year drop in cash operating profit of 14.5 per cent. The weak performance prompted the board to cut the dividend by 27 per cent to $0.10 per quarter, effective with the July 15 payment. That drops the forward yield to 8.7 per cent, which is still very high.

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In a statement, management said the weak quarterly results were due to lower returns from its key North American chlor-alkali business. Interim president and CEO Richard Ott said this segment continues to "face headwinds" and focused on the company's need to complete the expansion of its unit train transloading infrastructure.

What we have here is a company whose core business is going through a difficult phase while it waits for hoped for contributions from what until now has been a relatively small part of its operation, rail transloading. It may happen eventually, but there is too much uncertainty surrounding the stock right now to continue holding it.

The Canexus experience is a classic example of the risk in a high-yield stock coming back to bite investors. It serves as a reminder not to overload your income portfolio with issues like this and risk-averse investors should avoid them entirely. Stick with good-quality blue chips like BCE Inc., which currently yields 5 per cent.

Those who are willing to accept a higher level of risk in exchange for heftier returns may wish to include a few high-yield stocks in their mix but I suggest limiting the allocation to no more than 15 per cent of the total. Don't let greed override common sense.

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