To many investors, buying high-yield stocks is like picking up nickels in front of a steam roller. It feels like really easy money until you make one mistake and get crushed.
Take Annaly Capital Management, Inc. (NYSE: NLY) for example. This high-yielder was trading at $16 in early May before falling lower in the next few months and bottoming out around $10. The company's dividend yield of 9.5% at the time was an attractive source of income but the 25% capital decline left investors with a net loss.
But while it's true that high-yield stocks carry unique risks, the reality is that they don't have to be high risk as well. In fact, there are many high-yield stocks that are a screaming buy. And today I am going to share a few of my favorite strategies to find those rare opportunities. Not only does this give investors a chance to lock in a super-high yields, it also provides support on the chart and the potential for big capital gains. And that's a powerful 1-2 punch for any portfolio.
Focus On Dividend Growth Rates
Current yield is great. Every investor wants a big stream of income. But for most investors, a high dividend growth rate is just as important. That's because of yield on cost. Yield on cost is the dividend rate based on cost basis. And companies with even moderately higher dividend growth rates produce much higher yields on cost in the long run.
In the example below, company 1 has a current yield of 4.5% and company 2 has a current yield of 5%. On the surface, it might be tempting to reach for the higher yield. But company 1's 10% dividend growth rate produces much bigger yields in the long run, jumping from an already respectable 4.5% to 12% in just 10 years. In the meantime, company 2 with a 3% annual dividend growth rate only climbs to 7%.
Historical dividend growth rates are no sure indicator of future growth rates. But investing in companies with strong histories of raising dividends puts the trend in your favor.
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Payout Ratio
There are generally two different paths a stock can travel to becoming a high-yielder. The first is the path of the tortoise, with management slowly increasing dividends over the course of many years. The second is the path of the hare. This happens when a company's share price crashes and yields artificially spike higher.
For a deeper look at the sustainability of a company's dividend yield the place to look is its payout ratio. The payout ratio measures the percent of a company's income it pays out in the form of a dividend. Payout ratios between 25%-50% are generally considered to be high quality and financially sustainable.
Take Windstream Holdings, Inc. (NYSE: WIN), a telecom services provider and the highest yield in the S&P 500 at 11.6%. Once again, this juicy yield looks tempting. But with a dividend payout ratio of 2.5 (calculated as dividends/net income), this yield looks unsustainable. That's a sharp contrast to FirstEnergy Corp (NYSE: FE), another member of the S&P 500 with a dividend yield of 6%. That 6% isn't as glamorous as 11.6%, but with a dividend payout ratio of 0.61, it looks built for the long run.
Funds from Operations FFO
Many high yielders come in the form of real-estate investment trusts (REITs). The distinguishing characteristic of a REIT is that it's required to pay 90% of its taxable income as dividends to its shareholders. That makes REITs popular destinations for high-yield investors. But unlike regular stocks that are valued based on earnings and a P/E (price-to-earnings) ratio, REITs should be valued based on funds from operations (FFO). This is an important distinction because earnings and funds from operations can vary sharply in the same quarter or year. FFO can then be divided by market cap to identify the most undervalued high-yield stocks with the highest probability of advancing on a normalized or premium valuation.
The Investing Answer: High-yield stocks are a powerful source of income. But those high yields don't have to come with an extra helping of risk. Using these underappreciated strategies and metrics is a great way to not only reduce risk, but also find high-yield stocks in position for big capital gains and long-term dividend increases.
