With bond yields still near historically low levels, investors have increasingly focused on higher-yielding equities to provide cash flow. And there are certainly a lot of companies that pay dividends available. But sometimes the higher yields are just too good to be true.
When looking for dividend stocks we typically avoid the highest yielding names and look instead to those that yield less but offer greater sustainability characteristics.
We ran a backtest on Bloomberg to provide some clarity. With 13 years of available data, we broke the TSX down into deciles. Based on yield, the top decile contains the highest-yielding stocks, the second decile the next 10%, etc. Rebalanced monthly, we tracked the performance of these groups over time.
The findings clearly support the strategy of avoiding the highest yielding and focusing a little further down the spectrum; specifically, avoiding the top-yielding 10% and focusing on the next two deciles. While the top-yielding decile has nearly twice the dividend yield (8.6% vs. 4.7% for the second and third deciles) the lower-yielding group significantly outperformed. Furthermore, it did so with less volatility.
When one of the highest-yielding companies falls, they tend to fall fast and hard. Often, the highest yield is simply unsustainable.
Fundamentally, companies in the second/third decile group possess a higher margin of safety in the sustainability of the distributions. The median dividend payout of ratio for the top decile is 124%, while the payout ratio in the second/third group is 85%. That’s still high, but more reasonable.
One of the metrics we use is the Bloomberg Dividend Health score. It measures the health of a dividend, incorporating earnings, payout ratios, balance-sheet leverage and free cash flow. It also looks at the direction metrics are trending in. The second/third decile group has an average Bloomberg Dividend Health score of +4, while the highest-yielding decile is -9. Positive is good, negative is bad.