Every earnings season brings its share of surprises. Stocks of companies that disappoint are punished, while those that favorably impress are rewarded.

What often takes investors by surprise is just what’s considered positive or negative. Sometimes companies with seemingly bullish numbers can get absolutely thrashed, even if they appear undervalued before they announce them. Similarly, other companies may appear pricey but tack on more gains after reporting absolutely dismal results.

It’s all about what investors value at the time–which basically boils down to perception. A company in a sector deemed on the right side of the macro environment will be forgiven far more easily a disappointing revenue or earnings number, than a company whose sector is believed to be on the wrong side.

Conversely, investors will often brush off good news reported by a company in an out-of-favor sector. And they’ll bid a good sector/strong number company further into the stratosphere, no matter how high priced it was to start with.

Anyone who’s stuck around the stock market long enough knows, of course, that this sort of market action is ephemeral. With the exception of truly dying industries, in-favor sectors eventually swap places with those out of favor. And very often the further prices go in one direction, the more violently they snap back in the other.

Earlier this year, most investors believed the global economy was accelerating. The chief worry was that rising commodity prices were pushing inflation higher.

In the dividend-paying stock universe, investors gravitated towards riskier fare, driving up prices and driving down yields. Dividend-paying natural resource stocks were particularly in favor.

Not many folks wanted to hear about strong balance sheets, dividend growth and the other hallmarks of a healthy company. One explanation I heard more than once during my travels this spring to Money Shows and local American Association of Individual Investor chapters was that they just couldn’t wait that long for yields to rise and needed to lock in hefty payment now.

The result was that dividend growth stocks essentially traded at a discount to stocks with huge yields and no growth. Now it seems the worm has turned, at least partly. Investors are still craving yield, and the higher the better. But we’ve also seen a few companies stumble, as the sluggish economy has prevented needed debt reduction and/or held back revenue. That’s sown the seeds of doubt and big yield companies have backed off.

To date, the only regulated utility to trim its dividend has been Empire District Electric Company (NYSE: EDE), and its circumstances were extreme. First, it hadn’t covered its payout with earnings for many quarters and wasn’t likely to the rest of 2011, as Missouri regulators granted only a fraction of a much-needed rate hike this spring. Then its Joplin, Missouri, service territory was struck by a devastating tornado, wiping out 10 percent of its load. Empire has eliminated its dividend for the rest of 2011. If all goes well with the recovery effort, it will resume payments in 2012, but at a rate of 25 cents per share rather than the current 32 cents.

Those are problems not shared by the rest of the 170-plus US essential-service companies I track in Utility Forecaster. In fact, only a few have any substantial risk to dividends. And the same is true of the vast majority of energy-focused master limited partnerships (MLP), which are in the sweet spot of strong demand for new projects and a still historically low cost of capital.

Utilities and MLPs, however, are in the dividend growth group. Yields are still generous in the 5 to 8 percent range. But their real appeal is extremely reliable total returns, as dividend increases propel their share prices to higher ground.

That’s an attractive proposition in any environment. And I strongly recommend every income investor own a healthy portion of both of these sectors. They’ll build wealth year-in, year-out. And if the global economy should really slow down, as many fear, there are few investments with a better track record of holding their own through the turmoil to ride the recovery.

After this selloff, however, there are again a large number of stocks with truly massive yields of 10, 12, even 15 percent and higher. Some of them, however, do carry very real risks. Despite quite juicy looking yields and the appearance of being cheap, they may actually be overvalued based on their realistic prospects.

Not every one of these stocks, however, is a high-risk case. In fact, some have been unfairly beaten down by rumor and innuendo, rather than actual business developments. For these stocks, it’s March 2009 all over again. Buying them will not only lock in a high yield, but also hefty capital gains when they prove their staying power and their share prices rebound.

Finally, there are the stocks that are so badly beaten they have almost nowhere to go but up, so long as they survive their current challenges. They may slash or even eliminate dividends before they recover. But as long as management is able to right the ship, they’ll ultimately reward patient risk takers with massive capital gains.

In general, I don’t advise this kind of stock for either conservative wealth-building or income investing. They may pay big yields, but they’re not dividend stocks. But no one should ever count on those payments to last. These are, however, often attractive as speculations for patient investors who have the stamina and patience to wait on recovery, and the cold-blooded perspective to let go if things don’t work out.

As readers of Utility Forecaster and Canadian Edge know, at any given time I’ll hold at most one or two high-risk/super-yield plays in my model portfolios. That way, even if things so horribly wrong in one of these positions it’s not going to really hurt performance. In addition, model portfolios at their best should reflect an advisor’s investing principles–and my cardinal rule is that wealth building is best achieved without the flash but by focusing on healthy, growing businesses. Read more about what we’re buying now here.  

There’s nothing wrong with taking a position in a riskier stock, however, as long as you’re aware of the risks and are not over-exposed. That’s the first rule for anyone who follows my advisory Big Yield Hunting, a service that identifies one 10 percent plus yielder each month that I co-edit with David Dittman.

Here are the rest of our Big Yield Hunting principles for investing in high yield/high risk stocks:

• Never overload on a single position and never double down when the price drops. No matter how thoroughly you research, not every position works out. Yields reach super-high levels precisely because there’s uncertainty about the underlying company’s prospects. When we enter a position, we’re playing the percentages that there will be a favorable outcome for investors. But if that doesn’t happen, we need to be mentally ready to get out. That’s much harder to do if you’re buying on the way down. Also, there’s no better way to turn a losing position into a disaster than to keep doubling down.


• Know the current level of dividend coverage by the relevant measure of profits. Most investors are used to gauging divided safety by comparing the payout to earnings per share. That’s fine in most cases, so long as you strip out any one-time items that can distort real profits, such as gains from asset sales or writeoffs. A growing number of high yielding companies use cash to pay dividends, including most of the former Canadian income trusts, US master limited partnerships, real estate investment trusts and wireline phone companies. The relevant measure for them will be “free cash flow,” “funds from operations” or “distributable cash flow.” These aren’t standard measures under Generally Accepted Accounting Principles (GAAP). But they are what management bases its dividend payments on.


• Always know the key catalysts that would trigger a rise in the stock’s price. A 20 percent yield on a $10 stock can be wiped out in seconds by a plunge in the share price to $8 for any reason. It may be worth holding onto the stock even then, but only if there are catalysts that can trigger a recovery.


• Always know the key risks to the current level of dividend coverage before entering the trade. Profits can be affected by many factors. Knowing the factors that can take them down and recognizing them is the key to being able to exit a super yield stock position before real damage is done.


• Be aware of the company’s debt obligations, particularly maturities slated for 2011 and 2012. Nothing endangers a dividend like the need to cut debt, particularly if cash is desperately needed to pay off maturing bonds or credit lines. That’s true even now, with corporate borrowing rates at their lowest levels in decades. It will only become more critical if credit conditions tighten later this year.


• Don’t be afraid to take a profit, no matter how high the yield is. If a $10 stock yielding 20 percent rises to $12, the capital gain is worth an entire year of dividends. If it rises to $16, it’s three years of dividends. If you hold on and the stock retreats to $10, you may still get the 20 percent–if the dividend isn’t cut. But it will take you three years to get back to where you were.

Remember, super-yield bets are fundamentally speculations. They’re not a way to safely augment income. That means our focus always has to be on total return.

Think of it this way. If you book a 30 percent profit in one of these, you can buy 30 percent more of a far safer stock with a growing dividend. That’s essentially a 30 percent boost in the dividends you’ll get–and you’ll sleep easier knowing your risk is lower.