In his 2019 book, “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” Mark Lowe profiled a second “proven” dividend investing strategy — the High Dividend Yield Strategy (HDYS).
Previously, he described the high dividend growth rate strategy (HDGRS); it involved the use of growth-oriented stocks so investors could capture both dividends and capital gains.
In contrast, the high dividend yield strategy focuses on the level and sustainability of dividends, and gives little weight to capital gains. Lowe wrote, “High Dividend Yield Strategy (HDYS) is another major approach used by stock dividend investors. This game plan typically leads to substantial cash income from slow-growth companies but are releasing high dividend payouts.”
Since HDYS investors want high or higher dividends, the emphasis in finding them is on valuations. If the price is down, the dividend will be up, given the mathematical relationship between them. Ideally, of course, we want to find stocks that are low priced because they are out of favor, and not because they have rocky fundamentals.
Most hunting for these stocks takes place among large and/or established companies that are past their aggressive growth stage. They will put less of their earnings or net income into retained earnings and more into dividends.
Advantages of the HDYS
As we might expect, most companies that fit the HDYS profile are in defensive sectors and as a result, are usually able to remain reasonably steady when there is economic upheaval. In part, that’s because they often have large cash reserves, allowing them to make dividend payments during short-term setbacks.
The measure by which HDYS stocks are evaluated is the dividend yield; it is calculated by dividing the annual dividend per share by the price of a share. For investors seeking passive income, this strategy is a logical one, especially if they reinvest their dividends back into the company.
As noted, these companies often are found in the defensive sectors, so they are less volatile and less risky, compared with the rest of the market. While not quite as safe as bonds, they usually deliver higher returns. Lowe added, “Companies in the defensive sectors include food, housing, utility, pharmaceuticals, and healthcare. Even during economic recessions, people still need to buy food, keep the lights on, and buy medicine when they are sick.” His examples included Coca-Cola KO and Proctor & Gamble PG.
These are normally stable companies, and as such, they tend to outperform. The author cited a study published in Forbes Magazine in 2015 that found, since the 1920s:
- The average annual growth of non-dividend stocks was 8.5%.
- The average annual growth of dividend stocks was 10.4%.
It also found dividend stocks are less volatile:
- The average deviation of dividend stocks was 18%.
- The average deviation of non-dividend stocks was 30%.
Disadvantages of HDYS
Lowe points to two key disadvantages of the high dividend yield strategy: Variable interest rates and no guarantee of dividend payouts. He added that, while investing in high dividend stocks can be an “amazing” opportunity, due diligence is essential.
Normally, investing in dividend stocks means investing in quality companies with strong management, but they still may be affected by poor market conditions or short-term internal problems. Such problems can force them to reduce or cut their dividends.
And interest rates can be a problem. For example, rising interest rates might make other financial instruments, such as bonds, more attractive. As a result, investors may fall behind and sell their stocks, thus incurring fees and potentially, taxes.
Speaking of taxes, Lowe did not include taxation as a disadvantage to the HDYS. For investors who are not operating inside a tax-protected plan, every dividend payout will be taxed. On the other hand, investors who invest for capital gains, as well as dividends, can defer at least some of their taxes. For example, if the returns are 100% from dividends, then 100% of each payout is subject to taxation. On the other hand, investors who choose a stock that returns 50% as dividends and 50% as capital gains, would defer half of their returns. Tax deferral means investors can keep using the money that otherwise would have gone to taxes until they sell their stock.
High dividends and underlying business problems
A high dividend is not always an attractive proposition. It may indicate the company is struggling behind the scenes, or perhaps, even in public view.
This example was provided by the author:
- Company S is trading for $100.
- It paid an annual dividend of $5.
- That made the dividend yield 5%.
- Afterward a problem occurs, and the share price drops to $50.
- Until the next annual payout, the dividend per share is listed as $5.
- Thus, the dividend yield may show as 10% for the rest of the year.
So, the dividend yield looks very attractive at 10%, but it is a temporary yield. If the problem that forced the share price down is not corrected, the dividend likely will be cut. On the bright side, if the problem turns out to be temporary, investors will have bought a bargain and a solid 10% yield.
Conclusion
The high dividend yield strategy is one of what Mark Lowe called “proven” dividend investing strategies. This conventional approach, with emphasis on the size of the dividend yield, is a conventional passive investing strategy.
There are several pros and cons to it; among the pros are the fact that this type of investing normally occurs among defensive stocks, securities that should be able to ride out short-term fluctuations in the market. The author also reported on research that found investing in dividend stocks outperformed investing in non-dividend stocks. In addition, dividend stocks had lower volatility.
The cons include the fact that this type of investing may be seriously disrupted by changes in interest rates and there is no guarantee that your dividend is safe. It may be reduced or eliminated if the company encounters adverse conditions.
Finally, investors should be aware that high yield dividends may mask underlying performance problems. In the example provided by Lowe, we saw how a high yield was not the result of good performance; it was high because the share price had dramatically fallen.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:Â
Dividend Investing: The High Dividend Growth Rate Strategy
Dividend Investing: 6 Considerations
Dividend Investing: Key Metrics, Part 2
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