Higher-yielding stocks often entail higher risk, which is why it's critical to evaluate these companies carefully before you consider investing in them.
Many investors make the mistake of looking at the high yield alone, which can set them up for disappointment if the company hits a pothole and has to cut its dividend.
In my Strategy Lab model dividend portfolio, I play it safe by sticking with modest yields in the range of 2 per cent to 5 per cent. But I'm not averse to owning higher-yielding stocks in my personal portfolio – if I'm confident the payouts can be sustained.
With these thoughts in mind, I invited Greg Newman, associate portfolio manager and senior wealth adviser with the Newman Group at ScotiaMcLeod, to discuss some of his current high-yield holdings.
"I think we all realize that usually the higher the yield, the higher the risk," he said. "As such, the core of our portfolios [comprise] high quality, established companies. Safeguarding capital is the most important rule of money management in our view."
That said, he will invest in higher-risk, higher-yielding names where he sees an opportunity. For example, the stock could be cheap relative to its peers or there could be a potential catalyst for the company that isn't fully reflected in the price.
"These stocks must be continuously monitored to ensure that the thesis is evolving as planned," he said. Here are some of his current holdings. Remember to do your own due diligence before investing in any security.
Yield: 5.5 per cent
Baytex is expected to close its acquisition of Australia's Aurora Oil & Gas this month, giving the Calgary company a stake in the Eagle Ford shale play in Texas and increasing its exposure to light oil. Baytex plans to boost its dividend by 9 per cent after the deal closes, and with double-digit cash flow growth expected in 2014 and 2015, "we anticipate dividend growth over time," Mr. Newman said. Although the payout ratio is above 100 per cent of cash flow when capital expenditures are included, the dividend is sustainable because Baytex stands to reap the gains of current investments for years to come, he said.
Yield: 8.0 per cent
Exchange Income, which my colleague Brenda Bouw profiles in more detail here operates in three niche business segments: aviation, manufacturing and infrastructure.
Mr. Newman expects cash flow to grow strongly over the next couple of years and said the stock could potentially benefit from margin recovery in its underperforming WesTower Communications subsidiary.
The stock trades at an EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) multiple of 4.5, based on 2015 estimates, which is less than Scotia Capital's "sum-of-the-parts" target of 6.75.
Yield: 8.1 per cent
Student Transportation is the third-largest school bus operator in North America, focusing on rural and suburban areas in Ontario and the United States. Revenue is growing steadily from new contracts and additional services, and Mr. Newman considers the dividend sustainable with a payout ratio of about 85 per cent of estimated 2014 cash flow. The shares trade at an EV/EBITDA multiple of about nine, which is below the five-year average of 10.4.
Yield: 4.8 per cent
Oil and gas producer Whitecap is "a prudent acquirer and a top tier operator" with a solid balance sheet and strong projected cash flow growth, Mr. Newman said. Having recently made accretive acquisitions, the company is in a position to boost its dividend significantly. Risks include lower oil prices and drilling program execution, but the stock is trading at a discount to its peers.
Chartwell Retirement Residences
Yield: 5.0 per cent
Chartwell owns retirement and long-term care homes in North America. Adjusted funds from operations (AFFO) are climbing, and the estimated payout ratio (distributions/AFFO) of 76 per cent in 2014 is expected to fall to 66 per cent in 2015. The stock trades at a multiple of about 13.5 times estimated 2015 AFFO, which is line with the real estate investment trust industry average, but potential "catalysts for a higher valuation include selling non-core assets, continued above-average organic growth and being a potential takeover candidate," he said.