How Safe Is Your Yield?
Stocks with dividend yields far above the market average often attract income investors looking to lock in a high yield during a bear market or broad-based correction. But stocks with high dividends can present special risks that investors would be wise to avoid. The following guidelines provide direction for further stock research to help you identify companies with reliable dividend yields.
Avoid Accidental High Yield Investments
When a stock’s price declines, the dividend payment remains fixed at the per share payout for that stock. A stock price decline, however, drives the dividend yield higher because investors can buy more shares of the stock for the same initial investment. High dividend yields can be a sign of financial health, reflecting a company’s ability to sustain payments to shareholders. On the other hand, high yields that result from a stock price correction often point to issues in the underlying company. For instance, a stock might fall after the company revises its guidance, signalling to investors to expect slower sales or lower earnings in the next fiscal period.
Avoiding accidental high yield investments can be as simple as reviewing a chart for the stock. If you see a price decline of more than 10% and no recovery over the past year, faltering earnings may have caused the correction in the stock, thereby inflating the dividend yield. When weak revenue leads to a share price decline, traders will question the company’s ability to sustain higher dividend payments. The stock will then sell off in anticipation of a dividend cut, compounding losses for long-term holders. Don’t buy a stock where faltering earnings or revenue have artificially inflated the stock’s dividend yield.
Compare the Stock’s Dividend Yield with the Yield of Its Index
The dividend yield of an index is the average yield of all companies included in the index’s calculations. A stock’s dividend yield should be measured against an index made up of comparable companies. For example, you might want to compare a large cap company’s yield with the yield of the Dow Jones Industrial Average.
Comparing a stock’s yield with that of the S&P 500 (a broad measure of market performance) shows how the stock’s dividend measures up to the mean and median. If your stock’s dividend yield is much higher than the market’s, you may need to do additional research to ensure the safety of the dividend. If the yield is much lower than the market as a whole or those of companies in the stock’s sector, you’ll need to decide if the stock has other characteristics (such as a potential for capital appreciation) that compensate for the conservative dividend.
Buy Stocks with High Dividends and a History of Dividend Increases
A long history of payments and regular dividend increases provide evidence of a strong underlying business. Both the dividend itself and the financial health it suggests will attract long-term investors to the stock. Canada’s Bank of Montreal has paid a dividend for a century and half, and many companies listed on the New York Stock Exchange boast dividend records of 20 years or more. As reliable and rising yields encourage investors to buy and hold, regular increases provide stability to dividend paying stocks. Furthermore, dividend increases reflect the management’s confidence that revenue will be adequate to sustain larger payouts to shareholders. Finally, stocks with high dividends and good earnings visibility (evidenced by management’s confidence in future earnings) more readily find support in the market.
You can access dividend histories for publicly traded companies on free financial sites like Yahoo Finance, MSN Money and Morningstar.com. Company websites and investor relations departments also provide information on annual dividend payments to shareholders.
Choose High Yield Stocks with Low Dividend Payout Ratios
As a rule of thumb, investors should avoid high yield stocks with dividend payout ratios of 80% or more. Payout ratios above 75% suggest that the company will struggle to earn enough to maintain its operations and quarterly dividend payments. If the market believes that the company could cut the dividend, traders will punish the stock in advance of any announcement and regardless of ultimate fate of the dividend.
Stocks with high dividends can reduce volatility and improve returns in your investment portfolio. Doing your due diligence can help you to identify high yield investments with safe, reliable dividends. Despite the tremendous pressure of the credit and financial crises, many domestic companies kept their commitments to shareholders. That these stalwart enterprises stayed the course in the worst of times speaks volumes about the safety of certain dividend yields under normal, expected conditions.