Image Source: Julien Carnot

We want you to learn about a unique risk innate to the high yield space like the back of your hand. We'll explain the "information contained in prices" and talk about what you should be on the lookout for, the "avalanche effect." Order the High Yield Dividend Newsletter here.

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By Brian Nelson, CFA

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I received a question from a dear member of ours, and I think it may be helpful that I share the response. The question had to do with why we may be ultra-cautious on high-yielding stocks that are facing considerable price declines. The risk described below makes the high yield space uniquely different than other equity strategies, in our view, and I want you to know about this risk like the back of your hand, so you are not surprised by anything.

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Part of our process, especially that with respect to high yield ideas, involves paying very close attention to market movements. The market price of a stock can offer a signal that there may be something else impacting our thesis on the company more heavily than we originally anticipated. This could happen in situations when we may be too aggressive, or even too conservative, with our forecasts and the corresponding fair value estimates. Some may call what I'm trying to explain, "the information contained in prices." The market, for example, can be "wrong" at times, but sometimes the market price can also offer clues to help assess risks that may not have been extensively presented within the GAAP fundamentals. 

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However, there's another very relevant reason why market price activity is so critical to high yield ideas, and this is the big risk I want you to know about. Within the high yield space, in particular, the market price itself is a key component of the fundamental dividend/distribution thesis of the company given the capital-market dependency of many constituents. During the Financial Crisis, for example, we saw how helpful using pricing information was when banking stocks sold off aggressively despite items in their financial statements that may have suggested the moves may have been unwarranted. Their price declines then depleted their ability to raise equity, creating an "avalanche effect," and self-perpetuating weakness, at the very time that access to the capital markets was needed. 

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Similarly, from our perspective, the decline in the share prices of ideas in high yield space directly impacts their ability to raise funds, and as a result, impacts their credit strength, and therefore the strength of their dividend/distribution, revealing a similar potential risk as that of banking equities under stress needing to shore up their own capital positions, for example. Said differently, there is an increased likelihood of an "avalanche effect" in the high yield space (REITs, MLPs and the like) than in other arenas, per se.

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This is in contrast to many lower-yielding, cash-rich corporates that can cover cash dividends paid with free cash flow, meaning that they do not need continued access to the capital markets, and their market prices (as a proxy for access to external financing) may not be as important of a fundamental consideration with respect to the dividend/distribution. For general corporates with strong balance sheets and excellent free cash flow generation, investors can wait out the storm. For high yield ideas, however, capital-market dependence risk remains very real for them given the relationship of their dividends to free cash flow generation, and as a result, their share prices offer important indicators to overall financial health. Ignoring pricing activity with respect to high-yield ideas can be hazardous.

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The need for continued access to the capital markets for many in the high yield space is why, with respect to high yield ideas, we pay the most attention to credit quality, as offered by the rating agencies, and share-price movements, as equity is a key source of funding, too. Perhaps said plainly, the decline in the share prices of high-yielding equities can at times be a key reason to remove them from a diversified portfolio, given the corresponding depleted potential for capital-raising opportunities (as a result of the share price decline). Share-price activity is often beyond the control of a company, so to a meaningful degree, the health of the payout of a high-yield entity's dividend/distribution is also in part beyond its control, given the need for ongoing debt or equity capital, in most high-yield cases. 

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It may not seem so, but share-price activity is about as fundamental as it gets in the high-yield arena, given that new equity capital is a key source of funding for the dividend/distribution, in many high-yield situations. Because accelerated price declines can happen at times, share price activity offers new, fundamental information to theses in the high-yield space. High yield, in our view, is synonymous with high risk, and when it comes to equities that are very capital-market dependent as many in the high-yield space are, their share price activity is very important to pay attention to.

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The high-yield space is off to a very rocky start in 2018, but so is most of the market, and rising interest rates remain a key risk to the space for a number of reasons, not the least of which is the potential trade-off to lower-risk government paper in the event risk-free rates rise to higher levels. We continue to emphasize the concept of diversification within the high yield arena. If you liked this content, consider subscribing to the new High Yield Dividend Newsletter.

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Tickerized for some of the highest-yielding stocks on the market as of the time of this publishing. A version of this article was emailed to members of the High Yield Dividend Newsletter. 

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Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.

Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.