Sweet yields can bring sour consequences. Ironically, they also hold the promise of robust capital gains, if the underlying companies measure up to their business challenges better than investors expect.

Over the long term dividend-paying stocks follow companies’ payout growth higher. In the near term, however, they track the perceived risk to their dividends. And in the current market, investors are viewing nearly every industry with suspicion, petrified at being caught in a company reducing payouts.

That’s a 180-degree reversal of the mood this spring, when investors were chasing high yields wherever they appeared. And while we’re down from the record number of super yielders hit in early October, there are still a dozen companies in the Canadian Edge How They Rate coverage universe tossing off dividends of 10 percent or more.

These companies hail from a range of industries and come in many shapes and sizes. What they all have in common is an extraordinary amount of dividend risk is priced into their stocks. That means lower prices and therefore higher yields than their peers.

Investors’ aversion to risk in dividend-paying stocks is, of course, part and parcel of a global effort to cut risk this year. The catalyst continues to be the threat to eurozone economies, spawned by the erosion in creditworthiness of sovereign debt and its impact on the Continent’s banking system. That, in turn, has increased fear of tighter credit spreading worldwide, triggering a slide into a global recession.

On days when the situation in Europe seems to stabilize, yield premiums required to buy perceived riskier fare diminish, and stocks rally. On days when the news turns negative, the premiums widen and stocks fall. And given there’s no silver bullet to settle Europe’s woes quickly, it’s likely we’ll continue to see this kind of action for some months yet.

The bad days, however, haven’t stopped some dividend-paying Canadian stocks from rallying dramatically by reducing investors’ perceptions of dividend risk. Parkland Fuel Corp (TSX: PKI, OTC: PKIUF), for example, broke out to a new 52-week high this week, rising more than 60 percent from its low point on Oct. 4 even as the broad Canadian stock market has made little headway.

Nor have the good days prevented some stocks from widening out to ever-larger risk premiums. That’s in a very real way due to the crackup of Yellow Media Inc (TSX: YLO, OTC: YLWPF) this year. The company’s demise was due mostly to challenges unique to its business, mainly the inability to grow its digital directory business fast enough to keep up with accelerating erosion of its print directory operation. That made it impossible to service the debt management had taken on to grow the digital business.

The only company in How They Rate with similar pressures of a print business facing Internet competition is FP Newspapers Inc (TSX: FP, OTC: FPNUF), which doesn’t suffer Yellow’s debt problem. Yet many investors seem to be assuming any dividend-paying stock that drops in price is a potential Yellow. And even stocks that have otherwise rallied this year are vulnerable to such emotional flare-ups.

That’s why big yield hunting here in December 2011 is essentially betting that stocks treated like they’re the next Yellows will wind up as the next Parklands instead.

Not only will buyers lock in hefty yields for years to come. But they’ll also score big time capital gains, as investors’ perception of risk to their dividends diminishes.

I highlight the prospects of the dozen highest yielding stocks in the Canadian Edge How They Rate universe now, with dividends ranging as high as 20 percent. I identify the key risks of each and five worth buying now.

Wheat from Chaff

Below are two tables. The first is entitled “Higher Percentage Big Yields,” the second “Lower Percentage Big Yields.” Each shows how listed companies stack up according to the six criteria of the CE Safety Rating System.

The criteria are:

• payout ratio;
• earnings visibility and what it means for future payout ratios;
• debt-to-capital ratio;
• debt due through 2012 as a percentage of market capitalization;
• exposure of earnings to changes in commodity prices; and
• the number of dividend cuts the last five years.

The more criteria met, the higher a company’s Safety Rating. The biggest difference between stocks in the two tables is “Higher Percentage” listings meet more of these criteria and “Lower Percentage” listings, and therefore have higher Safety Ratings on average.

The Safety Rating doesn’t predict performance. It merely shows how a company stacks up against what are likely to be its key challenges over the next year.

The revised Safety Rating System I introduced this fall place a great deal of importance on a company’s debt, particularly how much of it is coming due over the next year–the likely time needed for credit markets to unfreeze again should Europe’s crisis really become a contagion, as so many fear.

As I’ve pointed out, the good news on this score is that most companies have made herculean strides toward terming out their debt, i.e. extending maturities out at least several years to eliminate near-term refinancing risk. As a result, even riskier companies have comparatively little debt coming due in the next year. Should a 2008 style credit crisis hit hard on these shores, they’ll be able to simply pull back offerings until conditions soften.

Moreover, the fact that so many companies have eliminated their near-term refinancing risk makes it much less likely we will see such a credit crunch. In fact even the companies on these lists have been able to refinance debt at preferential rates. A massive refinancing of mortgage debt by Extendicare REIT (TSX: EXE-U, OTC: EXETF) this year, for example, has enabled that company to offset a big cut in Medicare reimbursements and continue paying its lofty dividend.

Nonetheless, as the demise of Yellow this year proved, pressure from lenders to reduce debt will almost always lead to a dividend cut. Companies that have a large amount of borrowings maturing in the near term are most at risk to such a margin call.

Most experienced income investors know the value of tracking payout ratios, which are basically dividends as a percentage of the relevant measure of profits. That’s funds from operations or distributable cash flow for a growing number of Canadian companies, particularly those recently converted to corporations from income trusts.

No company can afford to pay a dividend indefinitely that exceeds profits. That’s why virtually every company that has a payout ratio of more than 100 percent winds up on the Dividend Watch List. Even a low payout company, however, can have an endangered dividend if the trend in profits is down, if there’s inadequate predictability of future profits, or if commodity prices have a heavy impact on profits.

That’s why I also have a criterion for dividend cuts over the past five years. Any company that’s been able to avoid a cut over that time has proven its ability to weather just about anything, from the worst credit crunch/crash/recession of the past 80 years to the imposition of the trust tax in January 2011.

In contrast, any company that has cut its dividend since early 2007 isn’t necessarily a serial offender. Several CE Portfolio holdings, for example, cut dividends when they converted to corporations but have since raised their payouts.

Market history does show, however, that when a company cuts its payout once it’s more likely to do so again. That’s because nothing points up business weakness better than a dividend cut. Mainly, you can’t pay out unless you’re earning.

And when a company falls short on that score, it’s not a good sign for future balance sheet strength or growth potential, either.

Since I launched the Canadian Edge Portfolios in July 2004, I’ve generally sold stocks that cut dividends. My biggest mistakes have all come from breaking that rule, i.e. sticking with a stock after a dividend cut, in expectation that it represented a nadir and a starting point for recovery.

That strategy actually works well when it comes to owning regulated US utilities, which I track in Utility Forecaster. And I’ve used it to good effect since I launched that letter in spring 1989. With very few exceptions, however, the Canadian stocks I track aren’t very utility-like. One slipup is all too often a warning of more to come. Selling after the cut may mean locking in a loss; in fact it usually will. But it’s also the surest way to prevent much worse damage down the road.

Not following my rule to sell dividend cutters turned relatively small losses into large ones in both Yellow Media and Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) this year. That’s why I advise zero tolerance for anyone taking a position in any super-yielding stock. In other words, a dividend cut isn’t a time to hang in and hope. It’s time to exit the position and look for something else.

If history is any guide, most of the dozen companies in the two tables won’t wind up cutting dividends this cycle. That means perceived risk to dividends will also eventually decline, and share prices will rocket higher. On the other hand, as long as the North American economy isn’t running on all cylinders, any of them–including the “Higher Percentage” lot–will be at risk to failing.

That means any of these stocks you buy should be in the context of a diversified and balanced portfolio. No one should average down in any of them. Nor should anyone set a stop-loss, but be resolved to see the position through to either recovery or dividend cut and exit.

If you follow those simple rules, you won’t lose much even in a worst-case. Meanwhile, you’ll be in the game for monster gains as well as some of the highest dividends on the planet.

The Best

“Higher-Percentage Big Yields” lists the five best super yielders in the Canadian Edge coverage universe. Three are Portfolio picks that currently rate buys: Colabor Group Inc (TSX: GCL, OTX: COLFF), Extendicare REIT and Just Energy Group Inc (TSX: JE, OTC: JSTEF).

Neither Colabor nor Just Energy has ever reduced its dividend. That includes weathering the 2008-09 market crash/credit crunch/economic recession, as well as when they converted from income trusts to corporations. Colabor actually began paying trust taxes some years before its 2010 conversion, which occurred in 2010. Just Energy, meanwhile, announced months prior to its January 2011 conversion that it would avoid a dividend cut.

Both have also covered their dividends comfortably with cash flow this year, despite challenging conditions in their respective industries. Colabor’s first-quarter payout ratio zoomed to 207 percent due to a series of margin pressures. The last two quarters, however, have seen a sharp rebound in both sales and profit margins, as a spate of strategic acquisitions has paid off.

The third-quarter payout ratio fell to just 79 percent. The 12-month payout ratio is 81 percent, down from 86 percent at the end of the second quarter. And the company was also able to buy back 328,000 more of its own shares.

Colabor’s food distribution industry is challenged by fierce competition arising from a combination of food-price inflation and a weak economy that’s hurt sales. The Canadian Restaurant and Food Service Association reported a 2.7 percent rise in commercial food service sales for the first half of 2011. This gain was entirely based on price, however, as volumes declined.

Colabor, however, reported a 3.2 percent increase in its third-quarter comparable sales growth, which excludes acquisitions. That reversed several quarters of declines and testifies to the company’s market skills and focus on geographic and product niches where it enjoys scale advantages. That’s a strategy the company has followed throughout its history, and the bigger it gets, the more able it is to grow.

Colabor’s balance sheet is also quite strong. The company has CAD113.5 million drawn on its authorized credit facility of CAD150 million, which matures Apr. 28, 2016. It also has CAD14.3 million left on a convertible bond that matures at the end of December. The convertible would be “in the money” in terms of exchange value on a boost in Colabor’s share price to just CAD10.25, so it may not involve any cash outlay.

The company was able to put cash flow to work to reduce obligations CAD12.5 million during the quarter–a high priority–and still meets all its debt covenants comfortably. These are a maximum total debt-to-cash flow ratio of 3.25-to-1 (it’s currently 2.82-to-1) and minimum interest coverage by cash flow of 3.5-to-1 (it’s currently 5.29-to-1).

Management’s goal is still to make the company a national player in the food distribution business. That eventually will require considerable expansion beyond the company’s current Quebec-Atlantic Canada-Ontario focus. And it will probably include a major merger or acquisition, as CEO Gilles C. Lachance all but ruled out “going greenfield” during the company’s third-quarter conference call.

This policy, however, is the best guarantee such expansion will be immediately accretive or nearly so, which is also a major positive for long-run dividend safety.

The key concern investors seem to have about Colabor is whether or not the past two quarters’ positive earnings trend can last, given the uncertain macro environment. For its part, management has been pretty up front that, in the words of Mr. Lachance, “it’s very difficult for us as managers to predict exactly what’s going to happen in terms of sales and things like that.”

Those aren’t exactly the words fearful investors want to hear, and it likely explains why the stock, though off its lows, continues to trade with such a high yield. But this is a company that’s used to fighting for those inches that are so critical for weathering tough environments.

We’ll find out a lot more when the company announces its fourth-quarter and full-year earnings, most likely in February. But based on what we know now, the stock appears to be pricing in too much dividend risk and looks set for a solid rise this year. Buy Colabor Group up to USD10 if you haven’t yet.

Bay Street is mostly bullish on Colabor, with two “buy” recommendations, four “holds” and no “sells.” Analysts are even more positive on Just Energy, with five “buys,” two “holds” and no “sells,” including an upgrade following the release of fiscal 2012 second-quarter earnings last month.

This enthusiasm, however, hasn’t been picked up in the broad market, as the marketer of natural gas and electricity continues to trade with a yield approaching 13 percent. The inescapable conclusion is many investors still seem convinced that the company is inexorably headed for a dividend cut. That’s despite management’s repeated statements that it’s on track to beat cash flow guidance this fiscal year, including Chair, President and CEO Rebecca MacDonald’s statement during the company’s third-quarter conference call that “we can comfortably maintain our dividend for the foreseeable future.”

In some ways, Just Energy is obviously suffering from what I would call “Yellow Media syndrome.” That is many investors are paying a lot more attention to stock-price movements than they are to management guidance, company operating numbers or even balance sheets.

And a drop in price for whatever reason is being taken for granted as a sign that someone knows more than they do, and that it’s time to exit positions.

That’s the same market psychology that takes every bear market to extremes, be it for a particular stock, a sector or the overall market. How Just Energy stock eventually fares, however, still depends squarely on whether or not its business remains healthy. And at least at this juncture that appears to be the case, despite conditions that Ms. MacDonald called “a third consecutive year of low stable gas and electricity prices, the worst scenario for our core five-year fixed-price business.”

These market conditions have reduced the growth of the company’s residential energy marketing business, its most profitable operation. And with North American shale gas in abundance, it’s likely to remain the case for some time.

Those adverse conditions, however, haven’t kept Just Energy from growing overall. Nor is there any reason to expect, based on actual facts as reported, that the company won’t be able to continue compensating by pursuing new profit opportunities, such as its very successful commercial sales and green energy efforts. Costs are steady, the company is holding customers at improved rates, commodity exposure is hedged, bad debt expense has dropped and there are no balance sheet concerns, refinancings or otherwise.

We’ll obviously know more about Just Energy when it releases its next round of earnings, which is projected for Feb. 10, 2012. At this point, however, this stock looks a lot more like a future Parkland–poised for big-time gains as dividend risk perception fades–than a future Yellow Media headed for meltdown. Just Energy Group is a bargain all the way up to USD16 for those who don’t already own it.

Extendicare draws a lower Safety Rating than either Colabor or Just Energy because it has reduced its dividend in the past five years, a cut to the currently monthly rate of CAD0.07 per share from a prior CAD0.0925 in February 2009. That was due to a series of pressures on margins in 2008, including costs related to shifts in Medicare policies.

Ironically, Medicare changes post the primary threat to dividends now. The company appears to have adjusted to an 11 percent cut in Medicare cost reimbursement with a disciplined program of operating cost reductions and aggressive debt refinancing, which I’ve described in detail in previous issues of Canadian Edge.

Unfortunately, the owner and operator of nursing homes is now being forced to brace for the possibility of a 2 percent across-the-board cut in Medicare spending starting in January 2013, should the US Congress fail to pass a deficit-reduction compromise. And with both political parties seemingly content to kick the can down the road until after the election, this is an increasingly likely outcome.

The good news is management does have some time to react and has already done so by boosting cash reserves an additional USD32.1 million. That was the biggest reason for the rise in the company’s third-quarter payout ratio to 91 percent, which should come down in future quarters. Without the reserve, the payout ratio would have been just 59 percent.

The constant graying of the North American population continues to increase demand for Extendicare’s services, which it continues to upgrade for higher margins.

The latter is showing up in improved Managed Care rates and positive changes in the patient acuity index. The company’s percentage of patients using higher margin “skilled” services also continues to rise.

All of these are positive signs for Extendicare’s ability to maintain its distribution going forward. But again until we get a read on how much Medicare spending is going to be cut, there will be uncertainty. And it will remain critical to watch every quarter’s results to ensure management is coping with a tough environment.

Management is now planning to convert to a corporation following a shareholder vote in May 2012, which could help cut costs further. The company plans to maintain “our current approach to distributions” and for now is affirming the current rate. That’s remarkable, considering the headwinds its industry is facing and the adjustments Extendicare has made.

And it’s why Bay Street has remained generally bullish on the company, despite a drop in price this year. Extendicare REIT is a buy up to USD10 for those who don’t already own it.

I discuss prospects of AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) and Superior Plus Corp (TSX: SPB, OTC: SUUIF) in some detail in Dividend Watch List. AvenEx exits the List this month, thanks to very solid third-quarter results, featuring a 31 percent jump in oil and gas production and a payout ratio of just 60 percent. The company also has no near-term debt maturities and bank debt-to-annualized cash flow is less than 1.4-to-1.

The challenge for AvenEx’s dividend, like that of all oil and gas producers, is what happens to energy prices. The company cut its dividend to CAD0.045 per share in 2011 to reflect its conversion from income trust to corporation. But it was also forced to cut from CAD0.083 to CAD0.06 per share in mid-2009, in response to the titanic crash in energy prices and historic credit crunch/recession.

That broke an unblemished string of increases dating back to the company’s launch as an income trust, which was first announced in September 2002.

AvenEx’s historic strength of dividend lay in the fact that it also operated businesses that were relatively more stable than natural gas and oil production. Those included now mostly disposed of financial services and real estate. Today’s company is far more leveraged to energy prices.

That should be a plus going forward, particularly as the company increases production and tilts its focus toward liquids and away from depressed natural gas.

The bottom line is barring a steep decline in energy prices, AvenEx’s distribution looks solid. The company’s small size still makes it considerably riskier than the energy producers in the CE Aggressive Portfolio. But for more aggressive investors, AvenEx Energy is a solid buy up to USD7.

Finally, Superior Plus’ trading history over the past year is basically a cautionary tale of why it usually pays to sell a stock the first time dividends are reduced–and to steer clear until it’s increased again. That would have been Mar. 10, 2011, when management cut the distribution to a monthly rate of CAD0.10 per share from a prior CAD0.13.5 in response to a cut in its profit guidance. Since then the stock has lost roughly half its value, and management has trimmed the payout by another 50 percent.

Why take a shot now? As I discuss in Dividend Watch List in both the November and the December issue, the new rate appears suitably conservative to hold under even the most dismal scenarios for the company’s diversified business mix. The cut also frees up cash flow to reduce debt even more aggressively, which severely reduces the possibility of a Yellow Media repeat.

Most important, investors are still pricing Superior to yield more than 10 percent, as though another dividend cut were imminent. That makes the stock a very good candidate to pull a Parkland from these levels. To be sure, Superior is for very aggressive investors only, as virtually all of its operations are economically sensitive to some extent. But patient investors who can stomach the risk, it’s a buy up to USD6.

The Worst

Those are my best shots of How They Rate companies yielding better than 10 percent. The seven “Lower-Percentage Big Yields” present a much less compelling combination of risk and reward.

True, yields are higher than those of the stocks in the other table. The problem is most present risks that make dividend cuts virtually inevitable, barring a dramatic, favorable turn of events. And that’s rarely something anyone should bet on, no matter how great their tolerance for risk.

All seven of these stocks are on the Dividend Watch List, and I’ve reviewed their prospects there this month, including recent earnings results. I currently rate Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF) a “sell” due to management’s draconian slashing of its 2012 profit guidance this week and resulting loss of credibility in my eyes.

I also rate New Flyer Industries Inc (TSX: NFI, OTC: NFYIF) a “sell,” as its business continues to contract under the pressure of competition and fewer orders for new buses from its target market of state and local government entities. I’d also avoid Ten Peaks Coffee Company Inc (TSX: TPK, OTC: SWSSF), formerly known as Swiss Water Decaffeinated Coffee.

The company’s history since its initial public offering in July 2002 has been one of regular dividend cuts. The first was a 35 percent cut in early 2006, in response to competition and the strengthening Canadian dollar. That was followed by a partial restoration of 6 percent in March 2007, a 60 percent haircut in mid-2009 and finally a 30.6 percent reduction to the current quarterly rate of CAD0.0625 with the conversion to a corporation this year.

That’s a combined reduction of 81 percent from the original rate. And with competition still fierce and the payout ratio consistently high, odds are heavy it won’t be the last. Moreover, the drop in dividend has been accompanied by a fall of 77 percent from the initial offer price.

That’s the very definition of a successful long-term short sale, and it’s still working now, with the stock down roughly 40 percent this year. Sell Ten Peaks Coffee if you haven’t yet.

As for Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF), Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF), FP Newspapers Inc (TSX: FP, OTC: FPNUF) and NAL Energy Corp (TSX: NAE, OTC: NOIGF), any or all of them may wind up avoiding the dividend cuts they’re clearly pricing in now. And doing so would give their stocks a huge lift.

Chorus Aviation’s situation appears to be particularly fluid, as it depends entirely on whether it can amicably settle a rate dispute with parent Air Canada (TSX: AC/A, OTC: AIDIF). The matter has been referred to arbitration and is unlikely to be resolved until sometime next year.

At this point the worst-case looks like a dividend cut of 30 percent, which would become likely if the arbitrator adopts Air Canada’s position in full. That’s clearly a lot less of a cut that the market is pricing in with a yield of nearly 20 percent, which would seem to suggest considerable upside for the stock when this is finally resolved.

This is enough for me to rate Chorus Aviation a “hold,” though again returns here depend on what are right now wholly unknowable factors. And this stock is definitely not for conservative investors.

That also goes for Canfor, FP and NAL Energy, though dividend cuts for them are by no means inevitable, either. Aggressive investors can hold all three. But given the uncertainties swirling about all of them, the five “Higher Percentage Big Yields” are far better bets for big yield hunters.