Due diligence Can Lead Investors to Some Solid Companies With Yields of about 5%.

It’s important to start with some basic financial analysis.

“The first thing that you have to look at is the company’s cash flows,” says Charles Lieberman, chief investment officer and managing partner at Advisors Capital Management in Ridgewood, N.J. “Are they sufficient for covering that kind of a yield?”

He points to

Simon Property Group

(ticker: SPG). The stock was recently yielding 5.1%, well above the 1.4% average for the S&P 500 index. The company, which owns and operates higher-end malls and outlets around the country, is a real estate investment trust, meaning that it has to distribute at least 90% of its taxable income to shareholders. The income that gets paid out is typically in the form of a dividend.

Jenny Harrington, CEO and portfolio manager at Gilman Hill Asset Management in New Canaan, Conn., oversees a portfolio that recently yielded 5.1% and had about 30 holdings.

“You cannot just run a screen and say, ‘Oh, it’s a 5% yield, and the earnings coverage is great.’ You have to dig in further and see what the future actually holds, what forward earnings actually look like, and what management is saying about that.”

The firm’s flagship U.S. equity income portfolio’s holdings include

New York Community Bancorp

(NYCB), which recently yielded 6.5%; retailer

Foot Locker

(FL), 5.2%; and

Western Union

(WU), 4.8%. All of their dividends are sufficiently covered by earnings, she says, adding that screening for high-yielding stocks is only a starting point.

“The screen is going to make 150 companies look good,” she adds. “But then, when you start digging, it’s a smaller handful that make the cut.”

David Katz, chief investment officer at Matrix Asset Advisors in White Plains, N.Y., generally shies away from stocks with yields in the neighborhood of 5%, owing to their risk.

However, the firm’s holdings include

Verizon Communications

(VZ), which recently yielded 4.8%, and biotech firm

Gilead Sciences

(GILD), 4.7%. Another holding,

Unilever

(UL), yields closer to 4%.

Katz characterizes those three stocks as “very safe, and we like all as one of 25 stocks in a portfolio, but we are much more upbeat about most of our other holdings.”

If a stock’s yield gets to around 5%, chances are that the price has dropped or stayed depressed. In that case, assuming the price remains stable, investors can clip the dividends akin to a bond holding.

But these stocks do have risks.

“It doesn’t do you any good to get a 6% dividend yield and the stock goes down 20%,” says Dan Genter, CEO and chief investment officer of Genter Capital Management in Los Angeles. Before buying those high yielders, he likes to see an attractive valuation.

Case in point: One of the firm’s recent holdings was Gilead Sciences. The stock fetches about 10 times the $6.48 a share that analysts expect it to earn this year, according to FactSet—in line with its five-year average. In theory at least, that valuation provides some kind of a floor for the stock.

Higher-yielding stocks also can have a big impact on portfolio construction.

Genter Capital Management has three equity income strategies: one for more traditional income stocks with a yield of around 3%, another for higher-yielding names with a yield of roughly 5.5%, and a third that focuses on environmental, social, and governance, or ESG, investing.

The last recently had a yield of 2.3%, a result that Genter ascribes to avoidance of higher-yielding sectors such as tobacco and energy that are less popular among ESG investors.

Genter says that assembling a portfolio of higher-yielding stocks requires a more concentrated group of holdings than a more standard equity income fund has.

“If you want to be concentrated, you can get to a 6%-6.3%” yield, he says. “If you want to be broad, with broad sector representation, then you can get to 3.5%.”

The firm’s broader dividend strategy has about 35 holdings. Going back to the beginning of 2004 through March 31 of this year, its annual return was 9.7%, versus 8.6% for the Russell 1000 Value Index.

The higher-yielding portfolio, launched in last year’s first quarter, recently held about 20 securities such as

AT&T

(T), whose dividend was recently reset lower and now yields 5.7%, and

IBM

(IBM), yielding 4.7%. IBM last year boosted its dividend for the 26th straight year.

Another important consideration is that a higher stock yield doesn’t necessarily signal that a company is in distress. A good example is a REIT.

“Instead of coming more from appreciation, [the return] is coming more from the dividend,” explains Lieberman. “So the dividend, per se, is not indicative of a higher-risk situation.”

That’s certainly true for a company like Simon Property Group, which late last year boosted its quarterly distribution by 10%, to $1.65 a share.

As of April 19, the stock had returned about minus 17% year to date.

Lieberman is undeterred, convinced that the company is a good play on inflation, partly because higher prices and revenue in the stores are eventually reflected in the rents collected, and the economy’s reopening. The quarterly dividend, however, is still below the $2.10 a share it was at prior to the pandemic’s onset in early 2020.

Still, last year, the company’s free cash flow totaled about $1.8 billion after paying out dividends of about $2.2 billion, according to BofA Securities.

“You have to look at each individual situation to evaluate it, but the most critical variable driving everything is dividend coverage and cash flow,” says Lieberman.

Write to Lawrence C. Strauss at [email protected]