Topic: Dividend Stocks

How to tell a high dividend yield from a risky one

May 24, 2016|by Pat McKeough

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You can’t fake a record of dividends, but a high dividend yield can be grounds for caution.

You can’t fake a record of dividends. That’s why we place a high value on a sustained history of dividend payments. And when you’re looking for income-producing stocks, a high dividend yield—but at the same time the reliability of those dividends—should be one of your most important investment considerations.

In some cases, a high dividend yield can also be misleading.

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The dividend yield is the percentage you get when you divide the current yearly dividend payment by the share or unit price of the investment. It’s an indicator we pay especially close attention to when we select stocks to recommend in our investment newsletters.

But an attractive yield, and especially a very high dividend yield, can give you a false sense of security. That’s because many investors have a tendency to think that all investment income is almost as safe and predictable as bank interest.

The fact is that investment income can dry up suddenly. Money-losing companies are sometimes unable to keep paying a long-standing dividend, and they sometimes spring the bad news on their shareholders with little or no warning.

When a high dividend yield means danger

To reiterate: a high dividend yield may be a danger sign. It may mean insiders are selling and pushing the price down. A falling share price makes a stock’s yield goes up (because you still use the latest dividend payment as the numerator to calculate yield—but the denominator, the price, has dropped). But when a stock does cut or halt its dividend, its yield collapses.

A classic case is the now defunct Yellow Pages Income Fund. When it first issued units in 2003, it was widely trumpeted by brokers and in the media as a well-established company (although we viewed it as the over-the-hill division of a formerly well-established company).

The company stayed in the limelight even though its high dividend yield—consistently above 10%—was a big warning sign. We never recommended the shares of Yellow Pages Income fund, advising investors to stay away from them.

In August 2011, the company’s credit rating was downgraded to junk status; in September 2011, it cut its dividend altogether. By then the yield was above 30%. The company has since restructured to cut its massive debt and re-emerged as Yellow Pages Ltd.—but the original shareholders of Yellow Pages Income Fund got nothing in the reorganization.

Dividends can be a big part of long-term investment gains

If you stick with top quality high dividend yield stocks, the income you earn can supply a significant percentage of your total return—as much as a third of your gains. And at the same time, dividends are more dependable than capital gains as a source of investment income.

Note, though, that when it comes to investment safety, a long history of steady dividends is more important than a current high dividend yield.

Good dividend stocks are a valuable component of any sound investment portfolio.

Here are six tips for picking the best dividend stocks:

1. Look for companies that raise their dividends. Stock prices rise and fall. Interest on bonds or GICs holds steady, at best. But the best dividend stocks like to ratchet their dividends upward over time—holding them steady in a bad year, and raising them in a good one. That also gives you a hedge against inflation. Over time these stocks can accumulate a high dividend yield.

2. High quality stocks + high quality dividends = a winning combo. Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks. For a true measure of stability, focus on companies that have maintained or raised their dividends during economic and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

3. Watch out for stocks with an unusually high dividend yield. Investors should avoid judging a company based solely on its dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price). That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend paying stock’s yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut. That’s why we recommend that you look beyond dividend yield when making investment decisions, and look for companies that also have established a sound business and have a history of building revenue and cash flow.

4. Look for a history of paying a dividend. One of the best ways of picking a quality dividend stock is to look for companies that have been paying dividends for at least 5 to 10 years. Companies can trump up quarterly earnings, issue press releases to appear to be making strong progress, but they cannot fake dividends. Dividends are cash outlays that an unsuccessful company could never produce. All the best dividend stocks have a long history of dividend payments.

5. The best dividend stocks feature hidden assets. When researching dividend stocks, take a close look at their balance sheets. Can you spot any hidden assets? For instance, when a company buys real estate, the purchase price goes on its balance sheet at the historical value of the asset. Over a period of years or decades, the market value of that real estate may climb substantially. But the historic purchase price remains unchanged on the balance sheet. At times, the hidden assets in a company’s real estate can even come to exceed the market value of its stock.

6. Top quality stocks with a high dividend yield dominate their markets. We look for  dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.

Are you invested in any stocks that you consider to have a high dividend yield? How have they performed for you? Share your experience with us in the comments.