Is High Dividend Yield Investing Dangerous?

This article on high dividend yield was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image (creative commons) by stevepb, edited by Broken Leg Investing.

“Over the long term, the return from dividends has been a significant contributor to the total returns produced by equity securities in markets studied.” (What Has Worked in Investing, Tweedy, Browne)

When I first began active investing, I grew infatuated with dividends. In fact, my first foray into active investing started when Apple and Microsoft first issued dividends. I didn’t know it at the time, but I joined a dividend growth investing trend that was gaining steam. Little did I know that I could have made much more money focusing on a high dividend yield.

You see, when I was digging into dividend investing initially, I made the mistake of researching solely online. I let random online strangers shape my thinking. I came across a lot of false claims that high dividend yield investing was . . . dangerous.

Why would high dividend yield investing be dangerous? That's what I thought when I read about it for the first time. The consensus was these companies would eventually cut their dividend due to poor stock performance and falling earnings.

This would leave you with no dividend and a quickly depreciating stock. At the time, I fell for this fearmongering. I didn’t know there was no data to support it. I later came to realize that these individuals relied on past experience and participated in narrow framing. Narrow framing in this context is focusing on a single stock rather than the overall return of your portfolio. Narrow framing can lead to overall investment losses and bad habits.

Value Investing And High Dividend Yields

While it is possible for a high dividend yield company that you are investing in to drop its dividend, there are ways to avoid these companies. The best method is, of course, value investing.

There are many value investors who succeeded immensely. Benjamin Graham and Warren Buffett come to mind. However, a lesser-known but highly successful investing firm, possibly the greatest of all time, wrote quite a bit about the value of high dividend yields.

This investment firm is Tweedy, Browne Company. How did this company succeed in beating the market where many other hedge funds fail? The answer may lie in its bottom-up approach to finding statistically cheap companies. In its dividend investing studies, it found high dividend yield stocks combined with low payout ratios produced the best returns. These were returns in excess of overall market returns. It also found that these returns beat stocks with low or no dividend yields.

Tweedy, Browne discovered during downward trending markets that high dividend yield stocks performed better than any of the other great strategies they studied. The principal of your investment decreased less than if you owned stocks that had low dividend yields or even no dividend yield. You also recouped your losses much faster due to the high dividends being reinvested.

High dividend yields are also a great way to fight inflation. Since they offer great yields during times of stock appreciation and dividend growth, you will have a much greater yield on price. As an added benefit and a great qualitative strategy many high dividend yield stocks are takeover candidates.

High Dividend Yield Stocks VS Junk Bonds

A few years after I invested in Microsoft and Apple, I decided to take the plunge and invested in some high yielding stocks; dividend growth investing just was not cutting it. I found a very high yielding stock in Dillard’s.

Little did I know, but the high yielding investment I made was not actually a stock at all, but rather a preferred stock. It’s basically a hybrid of a stock and bond, with the only positive benefit being the higher yield and stability of that yield. I had no idea at the time and wondered what the heck it was doing in my portfolio other than giving me a nice monthly paycheck. In the end, it provided me with no share price appreciation and only the monthly dividend checks to show for it. I knew I could do better.

The next place I looked was junk bonds. These are a debt instrument that a company issues in order to fund operations. The worse the credit rating the company has, the higher the yield on a junk bond. This accounts for the higher probability that the company will default on its debt. One reason junk bonds may not be beneficial is that they are not aligned with management. They are viewed as a negative on the balance sheet. While junk bonds offer a great yield, they are in no way superior to a high dividend yield stock.

High dividend yield stocks offer a twofold return on investment. While essentially getting the same return on investment as my Dillard’s preferred stock, I also benefit from share price appreciation. I know what you’re thinking what if the stock price depreciates? Well, that's the beauty of it. In a basket of cheap high yielding dividend stocks, you will be almost assured of this share price appreciation based on the study that Tweedy, Browne Company did. Essentially, if you pick a stock with great underlying fundamentals and a strong balance sheet, you not only will get the returns offered by a high dividend yield but also the price appreciation.

Broken Leg High Dividend Yield Strategies

Here at Broken Leg Investing, we have developed two strategies that capitalize on the overall return of your stocks and a strong income focus. These strategies are Simple Way 2.0 and Pay Daddy Net Nets.

At the end of his life, Benjamin Graham simplified his investment strategy. This became known as Graham’s Simple Way strategy. Here at Broken Leg Investing, we improved upon Graham’s simple way strategy, calling it Simple Way 2.0. The one major addition to the strategy is the addition of a yield above the market average. This, along with a few other variables, catapulted Graham’s simply way strategy to massive outperformance. It produced a compound annual growth rate (CAGR) of 23% over 17 years. This was even during the dot.com and housing busts.

If you seek an income-based strategy but don’t have a ton of cash to invest, the Pay Daddy Net Net strategy definitely outperforms. Tweedy, Browne discovered that the smallest companies tend to be the cheapest and produce the best returns. So, looking at net current asset value along with dividend metrics such as payout ratio, the Pay Daddy strategy was born. Not only will you benefit from a constant stream of income, but you’ll also benefit from the share price appreciation from a basket of these stocks.

Conclusion

My dividend investing strategy has evolved over the years and slowly matured to the most effective one high dividend yield. High dividend yield investing benefits from large dividend cash flows, with the added advantage of price appreciation. If I had discovered this strategy and taken up value investing as a whole much sooner, I would be much better off than I am today.

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