High-yield dividend stocks can reward investors twice. Not only do they pay an above-average income stream, but they typically produce market-beating total returns. Because of that, investors should seriously consider adding some of these wealth creators to their portfolio.
However, before investors jump into the biggest payout they can find, there are three key facts they should know about high-yield dividend stocks.
1. The highest yield isn't always the best performer
Many income-focused investors look for stocks that pay the highest yields. That approach, however, isn't the best one to take. That's clear by analyzing the performance data of dividend-paying stocks.
Wellington Management did a study of dividend stock payout ratios. It grouped dividend payers into five categories from the highest payout percentage to the lowest. They found that stocks with the highest dividend payout ratio -- 72% on average (which also tended to have the highest yield) -- outperformed the S&P 500 66.7% of the time over the last 80 years. However, stocks in the next bracket -- which had an average payout ratio of 41% -- outperformed far more frequently at 77.8%. That was the best level of the five groupings.
In other words, stocks that pay high yields, but not the highest, tend to deliver the best total returns for their investors.
2. Dividend growth matters more than yield
Another mistake income-seeking investors often make is overlooking the power of dividend growth. Stocks that have high payout ratios don't have the excess cash to invest in expansion opportunities. Consequently, their businesses can stagnate, leading to lackluster stock-price performance.
The data bears this out. According to a study by Ned Davis Research, stocks that had no change in their dividend policy generated an average annual total return of 6.88% since 1972, which underperformed the 7.3% total return of the S&P 500 over that timeframe. Companies that either initiated or grew their dividends, on the other hand, produced market-beating total annual returns of 9.62% during that period.
This data suggests that investors look for stocks that can pay a growing dividend instead of solely focusing on yield.
3. A double-digit yield can be a danger sign
Higher-yielding stocks often carry an elevated level of risk because they typically pay out a significant portion of their cash flow to sustain their dividends. If market conditions deteriorate, these companies might have no choice but to reduce their payouts and use that cash to make ends meet. The market often adjusts for this higher risk level by pushing down the value of a company's stock price, which in turn increases the yield. When a dividend yield gets into the double digits, it's often a warning sign that the company could soon cut or eliminate its dividend.
That has been the case with many master limited partnerships (MLPs) in recent years. As a result of the continued turbulence in the oil market, and some regulatory changes relating to MLPs, many of these entities have experienced hardship, which put pressure on their financial profiles. That caused the yields of MLPs like Buckeye Partners (BPL), Summit Midstream Partners (SMLP -2.44%), and NuStar Energy (NS -0.31%) to rise into the double digits. However, as the chart below shows, those sky-high yields turned out to be a warning sign that a dividend cut was on the way:
In each case, these MLPs reduced their overly generous distribution so that they could use the cash to pay down debt and invest in expansion projects.
To make matters worse, a dividend cut tends to sting twice. That's because investors not only lose a large portion of their income stream, but companies that cut or eliminate their dividends have historically underperformed the market by a significant amount. According to data by Ned Davis Research, dividend cutters and eliminators have produced a negative 0.79% total annual return dating back to 1972.
The highest yield doesn't always produce the best return
As the data clearly shows, investors shouldn't select stocks based on dividend yield given that the highest ones tend to underperform. Instead, they should look for companies that pay generously yet with enough room to spare so that they have the financial resources to continue growing. That's because companies that pay an above-average dividend that they can increase consistently have historically delivered market-beating total returns, making them the sweet spot for dividend-seeking investors.