Income-seeking investors tend to focus most of their attention on a stock's dividend yield. However, that approach can cost them thousands of dollars. I know this to be true because I've fallen for my share of dividend yield traps. These mistakes have taught me some valuable lessons that have changed how I approach investing in high-yield dividend stocks.
Here are three tips that should help income-seeking investors focus on the metrics that matter more than a stock's dividend yield.
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1. Growth matters more than a big-time yield
Dividend-paying stocks can be powerful wealth creators. Companies that pay a dividend have historically outperformed the market. According to data by Ned Davis Research, dividend-paying stocks in the S&P 500 have produced an average total annual return of 9.25% from the start of 1972 through the end of last year compared to a 7.7% return for the S&P 500. However, as the following table shows, dividend growers and initiators have outperformed all others by a wide margin:
|
Grouping |
Returns |
|---|---|
|
Dividend growers and initiators |
10.07% |
|
Dividend payers |
9.25% |
|
No change in dividend policy |
7.47% |
|
Non-dividend payers |
2.61% |
|
Dividend cutters and eliminators |
(0.35%) |
Data source: Ned Davis Research.
Because of that, investors should look past a stock's current yield to its growth prospects since that should earn them a larger return over the long term. That has certainly been the case for oil giant Chevron (CVX 0.04%), which has now increased its dividend for 31 consecutive years. That steady dividend growth has enabled Chevron to produce a more than 1,800% total return over that time frame, easily outperforming the S&P 500's roughly 1,200% total return during that period.
Chevron's top priority going forward is to maintain and grow its dividend. The company aims to invest a large portion of the cash it generates after paying shareholders into expansion projects that will increase its cash flow. That should give it the funds to continue boosting its dividend in the coming years.
2. Look for a high, but not the highest, payout ratio
Another thing investors should consider when looking at high-yielding dividend stocks is the dividend payout ratio, or the percentage of profits returned to investors. Higher-yielding stocks tend to have higher payout ratios. However, research by Wellington Management found that stocks with high, but not the highest, payout ratios outperformed the market more frequently.
Wellington put dividend stocks into five groups based on their payout ratios. Companies with the highest payout ratios -- 71% of earnings on average -- tended to outperform the market 77.8% of the time. Meanwhile, those with the second-highest payout ratios -- 41% on average -- beat the market 88.9% of the time. As a result, investors should look for stocks that have healthy payout ratios but still retain a meaningful portion of their cash flow. That not only provides a nice margin of safety for the dividend, but gives them funds to reinvest in expanding their businesses so that they can continue growing cash flow.
Image source: Getty Images.
3. Consider the whole financial picture
While the payout ratio is an important metric, investors should also consider a company's overall financial profile such as its balance sheet, cash flow stability, and capital spending requirements. One of the reasons Chevron, for example, has been able to continue increasing its dividend over the years even though it operates in the volatile oil market is that the company maintains a top-tier financial profile.
It currently has the second-best credit rating among large oil companies, backed by one of the lowest debt ratios in the sector thanks in part to the nearly $10 billion in cash it has on its balance sheet. Consequently, it has the financial flexibility to bridge funding gaps that might occur during periods of low oil prices. On top of that, the company can fund its dividend as well as its growth-focused capital investments on the cash flows it produces at $50 oil, which is well below the current price. That ability to weather periods of market turmoil increases the probability that Chevron can continue growing its high-yielding dividend in good times and bad.
These three stock tips could enrich your portfolio over the long term
Companies that grow their dividends tend to produce higher total annual returns than those that don't, which can add up over the long term. That's why investors should focus their attention on companies that can bolster their payouts on a consistent basis. That means not only putting a priority on growing their dividends but retaining enough cash to continue expanding while also having a strong financial profile that will enable them to weather future storms in the market. If investors follow these tips, they could make a lot more money over the long haul than if they bought a stock based on yield alone.
