Investors sometimes ask for my opinion of a company’s stock, based purely on the yield. I always caution them that a high yield could pose red flags that require further investigation.

That said, there are stocks that yield 6%, 8%, or even more that are reasonably safe. Today, let’s discuss why yields generally skyrocket and which warning signs you should heed.

MPLX Case Study

A company generally ends up with a high yield because the price has fallen. Consider MPLX LP (NYSE: MPLX). This master limited partnership (MLP) was formed by Marathon Petroleum (NYSE: MPC) to provide midstream services that include the gathering, processing and transportation of natural gas, natural gas liquids (NGLs), and crude oil and refined petroleum products.

In 2018, MPLX was trading at about $35.00 and paid an annual distribution of $2.45 for a yield of about 7%. In 2019, with oil and natural gas prices under pressure, and with an activist investor seeking to break up MPLX, units fell to $26.00. But the company was still raising the distribution each quarter. By year end 2019, the annual distribution had risen to $2.67, which pushed the yield up to 10.3%.

In March 2020, the collapse of oil demand due to the COVID-19 pandemic caused energy companies to collapse across the board. At its low, MPLX units fell all the way to $10.85, which pushed the yield to an astronomical 24.6%.

A yield that high means that the company is undervalued, that the yield is unsustainable, or both. When I see a yield that high, I either expect the stock to rally or a distribution cut. Or both could happen.

Check the Warning Signs

How is an investor to know? While there are no guarantees, you can look for signs. One is whether the company is generating enough cash flow to cover the dividend and continue to operate its business. Continued strong cash flow is a sign that the company doesn’t need to cut the dividend, regardless of how high the yield has gone. I would caution that companies have taken advantage of a high yield to make a cut, but they typically won’t if cash flow still supports distribution.

The second sign is to listen to public comments from the company, and to earnings calls. During the market plunge, energy bellwether Chevron’s (NYSE: CVX) yield spiked up to 9.5%. But Chevron CEO Michael Wirth went on CNBC and said:

“Our dividend is our number one priority and it’s very secure. We’re taking actions to preserve cash. It will have some impact on production in the near term, but we’ve stayed with our financial priorities, which include protecting the dividend.”

That’s a strong assurance that, despite the high yield, Chevron wasn’t about to make a cut.

Likewise, MPLX CEO Michael J. Hennigan said on the company’s first quarter earnings call that management had decided to leave the distribution flat, while waiting to see how the pandemic played out. That’s not a ringing endorsement, but investors could take further comfort in the fact that MPLX’s distributable cash flow (DCF), an important metric for MLPs, had grown from $757 million in Q1 2019 to $1.3 billion in Q1 2020. Coverage for the quarter was 1.44x, which still allowed the company to retain $319 million of DCF.

Investors could conclude that the high yields reported by MPLX and Chevron were at least reasonably safe, pending of course on how long the pandemic impacted earnings. There was risk, but it wasn’t the kind of risk that would have been inherent if cash flow was falling and CEOs were making highly ambiguous comments on the dividend.

MPLX Rallies

What has happened with MPLX since then? Units have rallied by 123% since the March lows. Remember, that’s one of the things that can happen when yields get really high. It means the company is undervalued and will likely rally. That sky-high yield of 24.6% has been cut to 14.7%, which is still a very high yield.

I personally know investors who bought MPLX in March that have doubled their money and are getting yields on their investment of more than 20%. They bought knowing that the underlying fundamentals of the company were still pretty good, even though the risk profile due to the pandemic has increased.

Yet, it is still possible that MPLX may cut its distribution. There is still risk due to challenges in the energy sector. But it represents a good case in which chasing yield presented an attractive risk/reward profile. More often than not, a company yielding more than 20% will cut its distribution, but MPLX’s fundamentals, as well as comments by management, provided reasonable comfort that they could maintain the distribution.

While it’s important not to blindly chase yields, it’s also important not to dismiss high yields without a deeper investigation. In the case of MPLX, it’s been very profitable for investors who chased its 20% yield.

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