Are stocks with high dividend yields the most prized finds or bad investments in disguise?
Stocks with a high dividend yield are a key part of a successful portfolio—but at the same time, they can give investors a false sense of security. That’s because some investors tend to think that all stocks with high dividend yields are safe. However, dividend payments are not nearly as predictable as bank interest. In fact, investment income like dividends can dry up in a heartbeat. Companies are sometimes unable to honour their commitments, and they sometimes spring the bad news on you with no warning.
At TSI Network, we feel that stocks with high dividend yields often offer you a warning sign—and that requires you to take a very close look at the sustainability of a company’s dividend.
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The biggest risk in stocks with high dividend yield
When looking for stocks with high dividend yields, you should avoid the temptation of seeking out stocks with the highest yields—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 with a high dividend yield that has been maintained or raised 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.
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.
Utilities and Canadian Finance are some of the best stocks with high dividend yield
We continue to recommend that you spread your investments out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). The proportion of your holdings you devote to each sector depends on your temperament and financial goals.
For example, if you’re an income investor, you may wish to place more emphasis on Utilities and Canadian banks. That’s because these firms generally pay high, secure dividends, and have long histories of raising their payments, even during downturns. However, you’ll still want to make sure your portfolio is well-diversified across most if not all of the sectors.
By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.
You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.
Dividend growth stocks are a welcome bonus—but focus on quality
As with conservative dividend-paying stocks, dividend growth stocks offer investors a measure of security. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.
However, it’s important to avoid judging a company based on the fact that it pays a dividend. Nor should you be tempted solely by a high dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price).
That’s because—as we mentioned earlier—a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend stock’s yield could be high simply because its share price has dropped sharply (since you use a company’s share price to calculate yield). That drop may signal investor anticipation of coming bad news.
As well, you should always remember that while growth stocks hold the potential for greater gains than conservative selections, they typically expose you to a higher level of risk—even if they are dividend-paying stocks.
That’s why we look beyond dividend yield when making investment recommendations, and look for dividend stocks that have established a business and have at least some history of building revenue and cash flow.
Bonus Tip: Canadian blue chips are among the best high-paying dividend stocks
A company with a long-term record of paying dividends is generally one that is most deserving of the “blue chip” label in its traditional sense. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.
That’s not to say there won’t be surprises that affect every company in a particular industry. But regardless of whether investors opt for stocks with a high dividend yield, picking well-established, dividend-paying stocks benefits most investors. Those stocks have the asset size and financial clout (including solid balance sheets and strong cash flow) to weather market downturns or changing industry conditions.
Canadian dividend stocks that meet our Successful Investor criteria offer both capital-gains growth potential and regular income. In fact, dividends are still likely to be paid regardless of how quickly the price of the underlying stock rises.
What’s more, dividends from Canadian companies may come with a tax credit. This cuts your effective tax rate.
All in all, it’s realistic to assume dividends from blue chip companies will continue to contribute around a third of your total return.
Do you seek stocks with high dividend yield? Have you added these investments to your portfolio? Please share your story with us.
This article was originally published in 2016 and is regularly updated.
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