High dividend stocks are attractive for many investors searching for income, especially those living off dividends in retirement because their high yields could provide a substantial income. Across the globe, numerous of the highest paying dividend stocks offer a high yield of 4% or more. Some dividend stocks have even yields above 10%.
Nevertheless, there is a downside to investing in higher yielding stocks, not all are a safe and solid investment. High dividend stocks do have a greater risk of cutting their dividends in the future and often the price return of high dividend stocks are below the benchmark.
This article shows income-seeking investors where to find the best high dividend investments, and how to recognize which high dividend stocks are risky.
What exactly is a high dividend stock?
There is no exact definition nor boundary given for ‘high yield’ dividend. For example, in today’s era of lower interest rates, a 4% dividend yield is relatively high. However, this is low compared to the S&P 500’s dividend yield in the ’80s.
The S&P 500’s dividend yield bottomed in 2000 (1.2%) and cruising around the 2% levels today.
Source: multpl.com
A 4% dividend yield looks like a sensible cut-off for the selection of high dividend stock. Particularly, for investors who are funding their retirements primarily with dividend stocks.
How to recognize which High Yield Stocks are risky?
High dividend stocks make great investments but are often not blue chips or well-known companies. The question is how to recognize and select the safest ones and avoid dividend cut like General Electric (GE) in 2017. Next, to understanding the business model and company itself, investors can use several indicators to assess a high dividend stock.
Dividend investors can easily determine whether the dividend is sustainable for the long run by looking at a company’s payout ratio.
The payout ratio is a key metric for quickly assessing dividend safety since it indicates what proportion of a company’s earnings-per-share is spent on dividend payments. The payout ratio is calculated as follows:
A low payout ratio, like 50% for a high dividend stock is a positive sign. Stocks with lower payout ratios can potentially continue to pay their current dividends, even if they see a drop in earnings. Furthermore, companies with lower payout ratios do have the possibility to increase their dividend payments over time.
A high payout ratio means that a company is using a significant percentage of its earnings to pay a dividend, which leaves less money to invest in the future growth of the business. A dividend payout ratio over 100%, means that the company is paying out more money to investors than it’s taking in. This isn’t a sustainable model and should be taken as a sign that dividend payments are at risk.
Although a clear threshold cannot be giving, selecting high dividend stocks with payout ratios below 80% is a good practice and often used by investors. Depending on the “personal” risk tolerance, higher risk investors could set a cut-off at 90%, while more conservative investor could set the cut-off somewhere between 50%-70%. One could take into account that dividend payout ratios are also linked to the sectors.
Next, to payout ratio, the price-to-earnings ratio is also widely used by investors as an indicator. Depending on the characteristics of the underlying business, a price-to-earnings ratio of 20 is a reasonably good value in today’s market.
For context, the average price-to-earnings (PE) ratio of the S&P 500 is around 20 at the moment. It is rare for S&P 500 stocks to trade for a longer period of time above a PE ratio average of 25.
Source: multpl.com
It is important to compare a stock’s price-to-earnings ratio to three references:
- The stock’s historical PE ratio
- The PE ratio of stocks in the same industry
- The PE ratio of the overall stock market (see S&P 500 example)
A high price-to-earnings (PE) ratio is an indication that the dividend stock is overvalued and could generate some negative price performance. A dividend stock with a PE ratio above 40 is in general not a positive sign.
Why High Dividend Stocks Do Matter
Dividend stocks are enabling income-seeking investors such as retirees to generate income from their invested assets, without the need to sell stocks.
In the long-run dividend-paying stocks and dividend growers are showing strong performances. Companies that grew or initiated a dividend have experienced the highest returns relative to other (S&P 500) stocks since 1972, with significantly less volatility.
Look at the total return of stocks, dividends are an important component. Historically, dividends have contributed approximately one-third of the total return for the S&P 500. In some decades, dividend income even accounted for more than one-half of total return.
Why Highest Dividend Yield is not always best
Investors seeking dividend-paying investments may make the mistake of simply going for the highest yields possible. A study conducted by Wellington Management, shows that “Highest” is not always automatically the best choice.
The study brought to light that dividend stocks offering the highest level of dividend payouts have not performed as well as stocks that pay high, but not the very highest, levels of dividends.
The research started with dividing dividend-paying stocks into quintiles by their level of dividend payouts. The first quintile (i.e., top 20%) consisted of the highest dividend payers, while the fifth quintile (i.e., bottom 20%) consisted of the lowest dividend payers.
The second-quintile stocks outperformed the S&P 500 Index eight out of the nine time periods (1929 to 2017), or 88.9% of the time, while first-quintile stocks came in second, beating the Index 77.8% of the time. Therefore, the “high” dividend stocks are beating the “highest”.
There are several favorite places for investors to look for high yielding stocks. Some examples are below:
- Warren Buffett’s Stocks
- Monthly Dividend Stocks
- Dividend Aristocrats
- Telecoms
- Utilities
- REITs
- MLPs
See also our dividend stock lists for US and European investors.
Warren Buffett’s Highest Yielding Stocks
Warren Buffett is perhaps the single greatest and most well-known investor of all time. His long-term track record of success is unmatched and a source of inspiration for dividend investors. His investment strategy is focussed on quality and long-term competitive advantages.
Berkshire Hathaway (BRK-B), Warren Buffett’s investment vehicle does not pay a dividend. However, Buffett’s portfolio encompasses many blue-chip dividend growth stocks.
The Berkshire Hathaway portfolio a good idea for income investors in search of safe and stable dividends.
The complete list of Buffett dividend stocks can be found on our Warren Buffett tracker page.
Dividend Aristocrats
The Dividend Aristocrats are a small group of 57 S&P 500 stocks with 25+ years of consecutive dividend payments.
They include many of the most well-known US dividend stocks around, some examples are below:
- 3M (MMM)
- AT&T (T)
- Coca-Cola (KO)
- Johnson & Johnson (JNJ)
- Procter & Gamble (PG)
- Wal-Mart (WMT)
Increasing dividends for 25 consecutive years means paying rising dividends every year through the Recession (2007-2009), the tech bubble, and more. The dividend growth aspect can also help to compensate a retirement investor for inflation. Next, to dividend growth, the Dividend Aristocrats index has also significantly outperformed the market. The S&P 500 Dividend Aristocrats outperformed the S&P 500 by an average of 1.80% per year.
Dividend Aristocrats score on aspects such as safety, growth, and returns. However, their dividend yield average is around 2.5%, which is slightly better than the S&P 500 average.
For high dividend investors, the top 10 highest yielding Dividend Aristocrats are below:
Final thoughts
Investing in high dividend stocks is a key strategy for generating income (and especially growing income) in today’s low-interest rate environment.
Safety and growth are important as well. The Dividend Aristocrats, Warren Buffett’s holdings and lower payout ratio stocks with higher yields, in general, are all great places to look for a combination of safety, growth, and income.