Pitfalls Of Chasing The Highest Dividend Yield

Back in early 2009 I sold my mutual funds and opened a discount brokerage account with TD Waterhouse. I had about $30,000 to invest, and after doing some research on individual stocks I was drawn towards investing in companies that pay regular dividends.

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At that time, the stock market had been beaten up pretty badly from the global market crash and there were plenty of bargains to be had. It was a great time to be loading up on dividend stocks, and I went after the ones with the highest dividend yield.

After a few months I made some adjustments to my portfolio when I realized that choosing a dividend stock involves a lot more than simply looking for the highest dividend yield. Here’s why:

High Dividend Yield Danger

Initially, I purchased stocks with the highest dividend yield using the Dogs of the TSX approach to investing, where you buy 10 stocks in the S&P/TSX 60 with the highest dividend yield, hold them for a year, and then replace them with the new list of 10 high yielding stocks.

This strategy is a variation of the Dogs of the Dow approach that was invented by U.S. stockbroker Michael O’Higgins, and it has performed quite well over the last few decades.

One problem with investing in companies with the highest dividend yield is trying to determine if the dividend is at risk of being cut or eliminated.  These stocks have often been beat-up due to poor earnings or a change in their business, hence the name “dogs of the TSX”.

Manulife cut its dividend in half back in August 2009.  Last summer, Yellow Media slashed its dividend from 65 cents to 15 cents to help cover their massive debt load.

Related: How Do You Know When To Sell Your Stock?

I also realized that I would be constantly turning over my portfolio with this approach, and instead I wanted to hold dividend stocks for the long term.

High Dividend Growth Stocks

If high dividend yield is not a good measure to determine which dividend stocks to buy, what else should investors look for?  Dividend growth investors typically look for stocks that raise their dividends consistently over time.

Here’s a chart that shows the 10-year dividend growth record of more than 30 Canadian companies:

There are a few ways that investors can use to find the best dividend growth stocks.

• Dividend Aristocrats – Stocks that have increased their cash dividends every year for the past 5 years are considered to be dividend aristocrats.  A good starting point is to research the individual holdings of the Claymore Dividend ETF (TSX: CDZ), which tracks the dividend aristocrats index.
• Dividend Achievers – Companies that have increased their dividends for 10 consecutive years are considered dividend achievers. The list is more stringent than the Canadian dividend aristocrats and would usually cover a full economic cycle to stress test the companies ability to maintain their streak of dividend increases. No indexes currently cover this list but the research can be worth the effort to weed out less financially stable stocks.
• Average Dividend Growth Rate – Some companies don’t increase their dividends every year but can still be considered dividend growth stocks due to a high dividend growth rate over a long period of time.  For example, the Canadian banks didn’t raise their dividends for a few years during the global economic crisis, but their 10-year average dividend growth rates were still respectable.
• Low Yield, High Growth – Stocks that are often ignored by dividend growth investors are the low yield, high dividend growth stocks.  Companies like Shoppers Drug Mart (TSX: SC) have a low initial yield of 2.5%, but boasts an impressive 15% average dividend growth rate over the last 5 years.  CN Rail (TSX: CNR) has a current dividend yield of 1.6% with an average dividend growth rate of 14.26% over the last 5 years.  They have increased dividends for 15 consecutive years.

Dangers of Chasing The Highest Dividend Yield

It’s important for dividend investors to remember that the search for yield does not simply mean chasing the highest dividend yield in the market.  Often times there are warning signs that accompany stocks with high yields and unsustainable dividend payout ratios.

Related: Criteria For Selecting A Dividend Growth Stock

Broaden your research to include stocks with a high dividend growth rate.  Even though the initial dividend yield may be lower, these tend to be above average companies that deliver above average returns over time.  This keeps the stock price high and the current dividend yield low; meanwhile you’re collecting the growing dividends while increasing the return on your initial investment.