High yielders are usually riskier and more volatile than dividend stocks with lower yields. And over the long run, they are proven to underperform safer, long-term, dividend-growing blue chips.
But that doesn't mean you shouldn't ever have large yields in your portfolio.
That's because, by following two simple rules, you can safely add higher-yielding stocks to your income portfolio.
Rule No. 1 is to avoid the highest yielders on offer.
According to a 2006 study by Credit Suisse, some high-yielding stocks did outperform their lower-yielding counterparts. But the best performers weren't the highest yielders.
Credit Suisse broke down the dividend-paying stocks in the S&P 500 into 10 sections (or "deciles") by their dividend yields — decile 1 being the lowest-yielding stocks and decile 10 being the highest-yielding ones.
Although stocks that had the lowest yields (deciles 1 and 2) underperformed the S&P 500, higher-yielding ones (deciles 8, 9 and 10) outperformed the index by three to five times.
Take a look at this chart from the study. It shows how the top three deciles (highest yielders) did, compared with the bottom two (low yielders) and the S&P 500.
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Logically, if the lowest-yielding stocks were the worst performers, you'd think the highest-yielding ones would be the best performers. But that wasn't the case. The eighth and ninth deciles outperformed the 10th decile (the highest-yielding stocks in the S&P 500).
The reason for this seeming inconsistency is that companies that pay out too much of their earnings in dividends often can't afford to do so for long.
And this brings us to rule No. 2: Make sure the companies whose shares you buy can afford to keep paying their dividends.
The best way to do that is to look at something called the dividend payout ratio. This simply measures the percentage of earnings a company pays out in dividends (yearly dividends per share divided by earnings per share).
Too high a payout ratio points to higher risk of a dividend cut down the road. (It doesn't take much more than one bad quarter or failed product launch for a company to end up without enough income to pay its dividend. So it is forced to cut its payment.)
Credit Suisse also found that high-yielding stocks with lower payout ratios outperformed high yielders with high payout ratios.
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In my subscription-based income advisory service, Income & Dividend Report, I look for a yield no higher than 10% and a payout ratio between 35% and 70%.
One play that fits this perfectly is Total SA (TOT), the largest oil and gas company in France. It has operations around the world. And last year, it had net income of more than 10.7 billion euros.
TOT yields 6.3%. And its payout ratio sits right at the bottom of our "sweet spot," at 38%.
So if you already have built in the kinds of "bedrock" dividend payers I told you about last week... and are looking to add some higher-yielding dividend stocks... Total is a great first choice.
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