Friday, 27 November 2009

Three distinct yield categories of stocks

Income investors should focus their search on dividend stocks that have yields high enough to generate the income they require.  If you need an income stream equal to 4 percent of invested capital, then you should look for stocks with yields int he 4 percent range. 

There are thousands of stocks, so to make your job of finding the right dividend stocks easier, we suggest you mentally group them into three distinct yield categories:

Category 1:  Low-yielding stocks
These are issues that have a dividend yield of less thant he yield of the S&P 500 Index.  The yield on the S&P 500 Index is about 1.5%.

  • Although they do pay a dividend, they tend to reinvest most of their earnings to foster growth in value through price appreciation. 
  • These stocks are very appropriate for growth investors, but they may fail to meet your income requirement.
Category 2:  Medium-yielding stocks
These are issues with dividend yields that are equivalent to the index's yield or higher and tend to be companies focusing on providing a balanced return from both dividends and price appreciation.

  • When screening for stocks, we target stocks with yields that are at least 150 percent of the index's yield.  They are committed to their dividend program and pay out from 30 to 50 percent of earnings in dividends. 
  • You can shop in this group for income, but remember that the object of your search is to find stocks that meet your income requirement, so you should concentrate on stocks with higher yields.
Category 3:  High-yielding stocks
These are issues with yields today in the 4 to 5 percent range or higher and are companies that are generally in mature industries that focus on providing investors with returns through dividends. 
  • They pay out 50 percent or more of their earnings to attract investors to their high dividend yield.
  • Mature industries that fit this category are utilities, banks, pharmaceuticals, energy and real estate investment trusts (REITS).  The high yields of REIT stocks can be compelling.
  • You will be able to find a fair supply of high-yielding stocks with dividend yields equivalent to most bonds' yields.  It just depends on where you look. 
  • You can find stocks with yields in excess of 4 percent from mature companies in certain industries like utilities that focus on attracting investors to their high dividend yields.
  • You can also find undervalued stocks with juicy yields that have fallen out of favour with investors.  In many cases, their price has declined while their dividend has remained stable, increasing the stock's yield in the process.  Analyse these situations carefully to determine why the stock has declined in price and if its dividend is secure.  There is often a fundamental business reason why the stock price is declining:  failing to meet earnings expectations, declining revenue, increasing debt levels, etc.  Your job is to determine if the price decline is a temporary setback or part of a larger negative trend.  If you're confident that the pricing adjustment is based on temporary conditions that you see improving, then you may have found a nugget of gold!

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