Why these 8% dividend yields may not last much longer

Updated: 
Card Factory

After years of low interest rates, profitable companies offering dividend yields of more than 8% are likely to attract some attention.

These yields won't stay this high forever. Either the underlying dividend will be cut, or the share price will rise. In either case, the yield will eventually fall.The key to success in high-yield investing is learning how to recognise the potential winners.

I've taken a look at two mid-cap stocks with forecast dividend yields of more than 8%. Are these torrents of cash affordable, and can they be maintained?

Dividend greetings

Low-cost card retailer Card Factory (LSE: CARD) is a common sight on the UK's high streets. It's one of the few big retail chains to have reported steady growth and expansion over the last few years.

Card Factory shares currently trade on 12.5 times current year forecast earnings, with a colossal prospective yield of 9.8%.The reason for this is that this year's forecast dividend of 24p per share includes a 15p special dividend. Without this, the yield would be about 3.7%.

Card Factory's decision to pay a special dividend this year reflects the group's strong cash generation. City analysts who cover the stock have pencilled in another special dividend for next year, giving a forecast yield for 2017/18 of 8.4%.

My view is that these special payouts are probably affordable. Card Factory's operating margin is very high, at 23%. Cash generation is strong.

However, the growth outlook for Card Factory looks less certain. Although revenue rose by 4.8% to £169.2m during the first half, this was due to new shop openings. Like-for-like growth was only 0.2%.

Worryingly, Card Factory didn't mention like-for-like growth in its Q3 trading statement. This suggests to me that like-for-like sales may have turned negative. We don't know, because management chose not to tell us. For me, that's a warning sign.

Although Card Factory's dividend is tempting, I'd prefer to invest in a retailer with a more convincing outlook.

An unbeatable income from property?

Real-estate stocks often have above-average yields, but FTSE 250 firm Redefine International (LSE: RDI) is exceptional. This Real Estate Investment Trust (REIT) offers a prospective yield of 8.7%.

As a REIT, Redefine is obliged to pay the majority of its profits to shareholders in the form of dividends. But not all REITs offer such high yields. One thing that makes Redefine different is its relatively high level of debt.

The group's loan-to-value ratio was 53.4% at the end of August. That's fairly high for commercial property. In fairness to Redefine, one reason for this is that the group spent £490m acquiring a portfolio of properties from Aegon UK earlier this year.

This involved taking on £252m of new debt, but Redefine also refinanced much of its debt at the same time. The group's average interest rate is now just 3.4%, and none of its borrowings are now due to mature until at least 2020. The group's weighted average lease length is 7.8 years, so interest payments should now be well covered for the foreseeable future.

Management plans to reduce the LTV to 40%-50% over "the medium term". In the meantime, my concern is that Redefine could be vulnerable if property prices fall. Overall, I'd say debt risks make Redefine a hold, rather than a buy.

Don't ignore this ultimate dividend play

If you're looking for mid-cap stocks with high yields and the potential to deliver big gains, I'd urge you to consider this company. The business in question is a UK firm with operations in Europe.

Our experts believe this stock may be seriously undervalued. They reckon profits may be poised to rise sharply, as trading conditions improve.

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Roland Head 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.


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