Well-known investors such as Lord Lee and Neil Woodford seem to start their analysis of a stock by looking at the dividend and the potential a firm has to increase the dividend payment. Lord Lee reckons we can tell the health of the underlying business, and its outlook, by looking at the dividend record and the decisions the directors make about the dividend.
I find such a simplified approach to stock analysis to be appealing. However, the presence of a chunky dividend yield is not, in itself, sufficient justification to buy a stock. For example, Im avoiding shares in outsourcing services company Capita (LSE: CPI) and airline EasyJet (LSE: EZJ) and heres why:
Is this over-sold, or what?
Since the beginning of 2016, Capitas share price has plummeted by around 60% as the firm issued a series of disappointing trading updates. Neil Woodford, a big holder of Capita shares, summed up the situation in his funds end-of-year review, saying market confidence in the firm has been undermined and that he and his investment team have been, disappointed and surprisedby the firms apparent vulnerability to weaker trading in its more cyclical operations.
Indeed, at todays 505p share price, we can now pick up Capita shares on a forward price-to-earnings (P/E) ratio of just below nine, which stands in contrast to the double-figure rating of the last few years. The dividend yield looks attractive, too, running just over 6%. Maybe these shares are a bargain?
Neil Woodford thinks the effect of the firms weakness in trading has been magnified by a general perception that the companys balance sheet must be stretched because profits have fallen. But he points out that the directors announced the disposal of Capitas asset services division, which could help to allay investors fears about the balance sheet.
Mr. Woodford is keeping faith with Capita, believing that the market over-reacted to the firms profit warnings. He reckons, The share price now profoundly undervalues the fundamental long-term attractions of this business. He could be right, but Im not betting with him on this occasionbecause I believe that better options exist on the London stock market and its not worth taking the risk on a company that has just demonstrated its ability to surprise on the downside.
Turbulence ahead (probably)
Meanwhile, the sheer volatility of EasyJets shares and profit record demonstrates how vulnerable out-and-out cyclical firms are to changes in economic circumstances. Whether its unstable fuel prices, the effects that terrorism has on demand for the firms services, a general economic slowdown, or volcanoes erupting, there always seems to be something buffeting the fortunes of airline companies.
EasyJets share price has been a wreck since it looked unassailable during 2014, and everything that we might have learnedabout the futility of investing in airlines seems to be coming true, and its impossible to tell what might happen next for the company.
The firms dividend yield runs just over 4%, but I reckon investors need to be selective when it comes to investing in high-yielding stocks. So EasyJet joins Capita on my avoid list.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.