Stocks with high dividends are typically the most sought-after investments by investors. However, a high dividend yield can be a danger sign and a signal of problems to come

When a company’s dividend is reliable, its stock can offer great long-term value. If you stick with the kind of top-quality high-dividend-yield stocks our Successful Investor approach identifies, your dividend income could supply as much as a third of your gains.

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Stocks with high dividends are often a sign of investment quality

If you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

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 and 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. A history of dividend payments is one thing that all the best dividend stocks have in common.

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.

Dividend stocks are an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That’s why the majority of your stocks should be dividend-payers at all times. As you get older and closer to retirement, you should raise the proportion of dividend-paying stocks in your portfolio, to cut risk and improve the stability of your investment results.

Never overlook the negative attributes of stocks with high dividends

When looking for stocks with high dividends, you should avoid the temptation of seeking out stocks simply because they have above-average yields.

That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend.

Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks that pay a high dividend that has remained steady or risen during economic or stock-market downturns. Generally, 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 also provide an attractive mix of safety, income and growth. These are the kind of stocks we look for at the Successful Investor

Stocks with high dividends: When a high dividend yield could mean danger

To reiterate: a high dividend yield may be a danger sign. It may mean insiders among others 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 and most often its share price.

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.

High quality Successful Investor stocks + high quality dividends = a winning combo for the highest dividend stocks

A track record of dividend payments is a strong sign of reliability and an indication that investing in the stock will be profitable for you in the future.

Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So, as we mentioned above, if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

What do you look for as indicators of stability in stocks with a high dividend yield?