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High Yield Investing - 7 Important Questions to Ask

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An investor was recently featured in one of Singapore’s newspapers and the article generated significant buzz on the CNA and AsiaOne forums.

The story was newsworthy because the investor claimed to be able to receive yearly dividends of S$24,000, based on a portfolio of S$250,000 (as of November 2009). The portfolio has grown from S$130,000 since the start of the year, inclusive of capital appreciation and capital injections. The portfolio has almost doubled and is thus earning 9.6% in dividends annually based on current market prices, a seemingly impressive feat.

The shares in the portfolio are said to include CitySpring, Hyflux, First Shipping Trust, Pacific Shipping Trust, Suntec Reit, Cambridge Reit, Singapore Press Holdings and Singapore Post, many of which yield close to 10% in dividends.

Despite the disparaging debate (“He is a scrooge”) and condescending remarks (He’s trying to sell his books”) triggered by the article, the episode pointed out a need for investors to ask penetrating questions of the rosy pictures painted by a financial adviser, self-styled investment guru or even unit trust prospectus.

1. Did a fund or portfolio grow because of capital appreciation or capital injection?

This is a fundamental question which reflects on the performance of the fund manager. In an open-ended fund (or portfolio), if the amount of capital injection is not revealed (as is the case in the article above), there is no way to verify the capital appreciation of the seed fund. An investment fund that has doubled in size may have done so because it attracted new funds but made negligible returns for existing funds in the mean time.

2. How did a fund or portfolio perform relative to a relevant benchmark?

For example. the Straits Times Index has approximately doubled between March 2009 and December 2009. A portfolio comprising Singapore shares would thus be outperforming the benchmark only if it exceeds this threshold.

3. Are yields or dividends sustainable?

In general, high returns are easier to achieve in a short period of time, but becomes more difficult to sustain in the long run. High annualised returns from a most recent quarter may be attributable to one-off profits (distributed as a special dividend) or seasonal effects of business cycles. Dividends may be also paid out in the event of a capital reduction exercise (when companies distribute cash on their balance sheet for which they have no use for) and thus not sustainable. Moreover, a caveat about shipping trusts is that the underlying assets have a limited economical lifespan of 20 to 30 years and as such actual return on investment is about half of what the distribution payout suggests.

4. Are dividends reinvested?

In unit trusts prospectus, fund managers usually present past performance, with the assumption that dividends are reinvested. The key effect of reinvesting dividends is that this allows returns to compound, which is very powerful in generating even more returns. Therefore, if investors expect a regular dividend to be paid and not ploughed back into the portfolio, they should expect a lower return than the purported past returns of the investment.

5. What are the risks?

For every successful trader glorified, there are always many failures who are unreported. One of the issues of comparing yields between investment strategies is that the risk involved often gets glossed over (like in the Lehman minibonds saga). Similarly, the assets which achieved 9.6% returns are relatively safe equities, but nonetheless involve risks. The recent living proof is that of the MacArthurCook Industrial Reit, which had to conduct a “value-destroying” placement to raise more funds when it faced liquidity problems. Shipping trusts are also holding ship assets which are plunging in value to a level which may not yet be fully reflected in current unit prices. High dividends may thus be negated by declines in per-unit asset prices in the long term.

6. Were there any rights issues?

Right issues are double-edged swords which can reduce effective yield from a portfolio. In very good times, they may be seen as allowing existing shareholders to subscribe to new shares at a discounted price. More often than not, right issues compel investors to pour more funds into their original investments. Similar to declining share prices, payments to exercise rights can well exceed the dividends received. CitySpring Infrastructure Trust is a case in point: it paid per-unit dividends of 7.1 cents and 7 cents in FY08 and FY09 respectively, but raised 48 cents from unit holders via a rights issue in August 2009, effectively driving net returns negative over the past 3 years. CitySpring unit holders could of course choose not to subscribe to their rights, but doing so would have eroded the value of their original investments, diluted their ownership of the company and thus reduced their entitlement to future earnings.

7. Active or passive management?

Portfolios which are actively managed tend to attract higher transactional costs such as broker commissions. Such costs may eat into any dividends that are paid. Furthermore, active portfolio management can give increased returns by timing investments to short-term cycles (or even cum-dividend dates), but at an increased level of risk.

An investing strategy that aims exclusively to obtain high dividend yields can be a very rewarding strategy. It is likely that all things considered, the investor’s returns as reported in the article mentioned above are perhaps slightly less spectacular than at first glance, but enviable nonetheless. However, applying critical reasoning skills, learning to ask the right questions and reading between the lines are always important in investing, whether in interpreting a sensational news headline or prospectus.

Last Updated ( Friday, 04 June 2010 17:59 )  
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