The Risks and Rewards of High Dividend Yields

Matthew Carr By Matthew Carr
Emerging Trends Strategist

Dividend Investing

Successful investing is like building a house. It all starts with a solid, stable foundation.

For me, that foundation is made of companies every investor’s portfolio should contain – solid dividend payers and income generators. They stay strong, year-after-year, and spin off income.

A study by Columbia Management showed that companies that increase their dividend or initiate dividends outperformed non-dividend payers by a significant margin – 9.7% per annum compared to 1.7%.

High Dividend Yields

I rely on this foundation to give me 3%, 5%, or 7% each year in dividend yield (not including what the share price does). These consistent dividend payers give me financial security – even if a tornado, flood, hurricane, earthquake, or alien invasion comes along and knocks everything to the ground. At least the foundation will still be there. And I can rebuild.

In a market like we’re in now – which we have to accept as the new normal – these stable payers are imperative. But despite being considered the “boring arena” of investing, there are a lot of exciting things that dividend stocks can offer you.

One strategy is you can look for dividend stocks that yield 7% or more, where earnings outpace the dividend and the company’s business model is solid.

During a sell-off, companies see their dividend yield increase as their share price falls. But during a rebound, the inverse is true. By putting companies in your portfolio with a yield of 7% or more, you win twice as the share price moves higher, back to its average level.

If a 7% dividend yield is covered by earnings – which is a well above average yield – the company won’t be overvalued. And by and large, targeting 7% yields eliminates most large, blue-chip companies. That means the approach requires a little more due diligence, as the difficulty then becomes evaluating the company’s business model.

By removing big blue chips from this equation, you can focus on smaller stocks that have the ability to go up quickly in price while offering a high yield at the same time. The one warning here is to steer clear of companies with very small market caps – below $100 million.

Like most of the methods we use, this approach doesn’t limit your field of companies, it just narrows it to a more manageable range. For instance, right now, there are currently 96 companies with a market cap over $1 billion that sport a dividend yield between 7% and 15%.

But there’s always the fact that companies with yields above 10% have a tendency to be riskier investments. Sustainability of yield that high becomes the number one question.

The tried-and-true investing for income strategy is to go with “Dividend Aristocrats.”

Here, a high dividend yield isn’t as important. The focus is more about investors having to do as little as possible. Steady income checks are their primary goal.

The approach is simple, targeting companies with a track record of growing their dividend each year – preferably by a meaningful amount. Dividend Aristocrats are those companies a lot of investors are already familiar with, like McDonald’s (NYSE: MCD) or Coca-Cola (NYSE: KO).

These are dividend-payers that have increased their dividends each year for at least the last 25 years.

But as always, you must make sure the company’s dividend is safe. Look at the track record of raising the dividend, the amount of growth of the dividend and payout ratio based on cash flow, not just net income. Most people really only look at net income as evidence of dividend safety. But if the company isn’t generating enough cash to pay the dividend, it has to borrow the money to cover the payments or cut the dividend.

In both cases – the key piece is that the company has a consistent track record of returning cash to shareholders. Both dividend strategies focus on current operations, and not getting sidetracked by projections.

So, the main difference really comes down to how much time you’re willing to spend managing your portfolio.