Investors must be cautious when it comes to investing in high dividend stocks. Companies with high dividend yields can potentially offer very strong returns, but they can also lead to value traps and dividend implosions.
The fundamental question to answer with any high dividend yield stock is whether the yield is high because it is trading at an attractive valuation with a substantial dividend payout ratio, or because the dividend is out of control and ready to get cut.
Sectors with High Dividend Yields
Historically and presently, some industries have a lot of high dividend stocks to choose from. Tech companies and consumer products companies typically offer medium yields at best, but a few industries can regularly offer 4%, 5%, or 6%+ yields.
Telecommunications companies provide necessary infrastructure for the transmission of fixed-line and wireless communication signals. The industry is increasingly shifting from voice traffic to high-density data plans, making giving tailwinds to the telecom sector.
AT&T (ticker: T)
Vodafone (Ticker: VOD)
Utility companies have historically been a classic “blue chip” investment, with high yields and stability. Dividend yields are generally moderately high, but dividend growth is often rather low.
Consolidated Edison (ticker: ED)
The Southern Company (ticker: SO)
Master Limited Partnerships
MLPs are one of the strongest areas to find big yields. They pay out almost all of their cash flows as distributions to unitholders, and usually continue to issue more units to grow.
Enterprise Products Partners (ticker: EPD)
Kinder Morgan (ticker: KMP)
Real Estate Investment Trusts
REITs are required to pay out 90% of their profits to shareholders as dividends. As such, they often have high dividend yields and low dividend growth. Real estate is rather strong against inflation and offers a form of diversification away from traditional equities.
Realty Income (ticker: O)
National Health Investors (ticker: NHI)
Other High Yield Stocks
Besides the common areas, there are times when a high dividend can be found in an industry that’s not normally associated with high dividends.
Leggett and Platt (ticker: LEG)
Novartis (ticker: NVS)
Check for Dividend Safety
In order to make sure a high dividend stock is worth your time, it’s essential to check a few things.
Dividend/Earnings Payout Ratio:
Divide the annual dividend amount but the annual EPS. If the result is over 85% or so, then be cautious. A mild EPS reduction could result in a dividend cut. Some businesses like MLPs and REITs can go above 85%, but for most other companies, this is the red zone.
Dividend/FCF Payout Ratio:
When dividends are particularly high, you’ll want to check another metric too. Divide the total dividend payments by the total free cash flow generated by the company over the course of a year. Are they adequately and consistently covering their dividend payments with true free cash flow generated from operations?
Interest Coverage Ratio:
Divide operating income by interest expense. The interest expense represents the interest the company is paying on their debt. You’ll want to see a comfortable multiple of operating income over interest payments; usually greater than 3x. Otherwise, interest payments could be catching up with income, and the debt situation and eventually the dividend could get out of control.
Dividend Growth Rate:
Check the dividend growth rate over the last 3 year period, and preferably a longer period as well. If the dividend isn’t growing more quickly than the inflation rate, then the dividend income each year would actually be decreasing in terms of real purchasing power even if the yield is high.
High Dividend Stock Ideas and Newsletter:
Check the alphebetical list of stock reports to find some good high yield picks. For additional convenience, make sure you’re signed up for the free monthly strategic dividend newsletter to get exclusive income investment ideas each month, including some safe high yield ideas: