Stocks with high dividends are typically sought-after investments, however, a high dividend yield is not always a good thing and can be a signal of problems to come

It’s important to avoid judging a company based solely on its dividend yield because stocks with high dividends can sometimes be money losers rather than bargains. For example, a dividend stock’s yield could be high simply because its share price has dropped sharply in anticipation of a dividend cut.

However, when a dividend is reliable then the stock can provide long-term value. 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.

The Growing Power of Dividends Learn everything you need to know in '7 Winning Strategies for Dividend Investors' for FREE from The Successful Investor. The Best Canadian Dividend Stocks to Buy: REITS Canada and other Top Canadian Dividend Stocks.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

High dividends are often a sign of investment quality in a stock

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, 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 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 that have a high-yield dividend 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.

Stocks with high dividends: 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).

Yellow Pages stayed in the limelight even though its high dividend yield—consistently above 10%—was a big warning sign. We never recommended the shares, 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%.

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.

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

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.

It bears repeating that 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.

Have you ever been lured by a high dividend yield only to see your investment fail?