By Troy MacMillan

May 1, 2016 | News

The Stock Market Part III

Buy/Sell Versus High Yield Shares

So far in this series we have looked at a general overview of the stock market and at different types of dividends. In this article, we’ll look at the positives and negatives of two trading strategies. One where the investor looks for stocks that yield high dividend payouts, and one where the investor looks for undervalued stocks hoping that their value will increase in the short-term so the investor can sell at a profit (be aware that buying and selling the shares can result in capital gains tax).

Following the high yield strategy, an investor will look for companies that are paying out high dividends on a consistent basis. The key figure to look for with regard to this strategy is the company’s dividend yield, which is the total value of dividends paid out per share during the course of the year, divided by the current share price. With the current RBA cash rate so low (2.00%), investing in high yield stocks could be a more attractive, yet still fairly conservative and safe investment strategy.

A note of caution. If you remember back to the first article in this series, dividends are normally paid out relative to the profitability of the company, so for a company to constantly pay out high dividends, it needs to be making consistently high profits. Which is fine if the company is also retaining some of those earnings to invest back into the company’s growth – purchasing new assets, maintaining existing assets and maintaining cash reserves if needed. If the company is distributing too much of its equity to shareholders (meaning the dividend yield is high, say above ten per cent), the value of the company can drop over time, as it no longer has sufficient equity to support its operations. As a result the share price can drop, and in a worst-case scenario, the company could collapse, leaving you without the high dividends and without stocks of any value to sell. You should also review dividend payouts over several periods to ensure it wasn’t a once off larger than usual dividend that you are basing your investment on.

Overall, looking for blue-chip companies that have successfully balanced high dividend payouts with sustained growth will provide you with reasonably secure, somewhat better than cash rate, investment returns.

A far more risky strategy is to look for under-priced stocks, wait for them to increase in value, and sell for a profit. Successfully managing this trick can provide you with large returns in a short space of time; however – and this is a pretty big however – if it was as simple as looking at the stock prices, selecting one that seems to be a little low and buying big, then every investor in the world would be a multi-millionaire. Using this strategy is a gamble. It can be a well-educated gamble if your broker has a thorough knowledge of the overall market, the industry in general and the company in particular, but if someone tells you they have absolute certainty that a particular share is going to go up or down, they are either being generous with the truth, or have inside knowledge of something that will effect that share price which, if they act on that knowledge, is insider trading – which is illegal.

Because share prices are related to the perceived value of the company, stable companies tend to have fairly stable share prices with only minor fluctuations unless something significant, like a merger, takeover or unexpected financial performance report, occurs. The shares that are likely to skyrocket are often the start up companies that can just as easily sink without trace, so ensure that if you invest in these stocks, it’s with money you can afford to lose. Also keep in mind that you need to cover any costs and fees associated with each trade when calculating how much the share price needs to change for you to earn the returns that you are looking for – and be prepared for some misses along with the hits.

If you are unsure how to proceed with investing in stocks, or have any doubts about the strategy that is best for you, please consult with a qualified advisor to ensure you have the greatest chance of success.

Words by Troy MacMillan.