A downturn in the market doesn't necessarily mean that your money is going to fly out of the window. Even when markets are in turmoil, it's still possible to make money on stocks. For investors facing a falling market, stocks with a high dividend yield can be a good investment. In many cases, stocks that offer a high yield are often a safer bet than growth stocks. Still, investors need to take care - not all high-dividend-yield stocks are winners.
Measuring High Yield
The dividend yield gives investors an idea of the cash dividend return they can expect from the money that they have put at risk in the stock.
Determining the dividend yield takes a bit of math, but it can make (or save) a fortune. Take, for instance, the hypothetical stock of a drug manufacturer: CompanyJKL. In December 2008, the stock's dividend was 32 cents per share each quarter. Multiply that quarterly dividend by four to get an annual dividend of $1.28 per share. Divide the $1.28 per share annual dividend by the stock price at the time, $16.55. The dividend yield for that company is 7.73%. In other words, if you bought CompanyJKL stock at $16.55, held on to it, and the quarterly dividend remained steady at 32 cents, you would enjoy a 7.73% return, or yield, just from the dividend.
While a stock's dividend may hold steady quarter-after-quarter, its dividend yield can change daily, because it is linked to the stock's price. As the stock rises, the yield drops, and vice versa. If JKL shares were to suddenly double in value, from $16.55-$33.10, the yield would be cut in half to 3.9%. Conversely, if the shares were to fall in value by one half, the dividend yield would double, provided that the company held its dividend payment steady. (For an in-depth look at this and other ratios, check out our Investment Valuation Ratios Tutorial and our Dividend Yield Calculator.)
A Bet in Uncertain Times
Stocks that deliver a high dividend yield can make your money work harder than most other investments. What's more, regardless of how the stock performs, the yield produces a nice recurring rate of investment return. As a result, high dividend yielding stocks can be a good place to put your money when markets are falling. This is largely because they are less volatile than other stocks, as investors are more willing to hold on to these high-income stocks through a bear market.
After all, the total return from a stock represents both the amount by which its share value appreciates and its dividend yield. For example, if a stock gains 10% in value and its dividend yield is 10%, the total return to the stockholder amounts to 20%. On the other hand, should the same stock lose value, stockholders will only suffer a loss if the share value falls by more than the 10% dividend yield. At the same time, high yields can put a floor on the stock's value, since a big drop in stock value will likely attract new investors to buy in at lower levels as the dividend yield increases.
In fact, it's been shown that investors can outperform the market indexes with high-yield dividend stocks. Michael O'Higgins, who helped to draw attention to the yield-focused strategy known as "dogs of the Dow," showed that by investing in the 10 highest-yielding securities in the Dow Jones Industrial Average (DJIA), investors could beat the average itself.
According to O'Higgins, this is because high dividend yielding stocks of the DJIA will typically be the laggards. By purchasing while the stocks are "cheap" and producing dividends, you can potentially beat other strategies and the market on average in a down market. (Learn more about this type of investing in Stock-Picking Strategies: Dogs of the Dow and Barking Up The Dogs Of The Dow Tree.)
Not Risk Free
Despite their relative safety, don't assume that a high dividend yield investment strategy is risk-free. There are plenty of reasons to be cautious with high-yield dividend stocks.
For starters, a hefty dividend yield can be a warning sign. After all, the share price is relatively low, signaling that investors are less enthusiastic about a company's growth prospects going forward or, even worse, the company is in trouble. If a company is unable to sustain its earnings and there is a slowdown in growth, it could be a warning to steer clear of the stock, even if the dividend yield is high. Make sure that the company isn't in so much trouble that a dividend cut could be in the works. (Explore arguments for and against company dividend policy and learn how companies determine how much to pay out in How And Why Do Companies Pay Dividends?)
Let's pretend CompanyJKL is facing this kind of development. Its hefty dividend yield of 7.73% at the end of 2008 was largely based on rapidly declining stock value. From 2004, JKL stock had fallen by nearly half, as some of the company's biggest drugs faced patent expirations and the company failed to create new blockbuster products. In a bid to push up its profits, in January 2009 JKL announced its intention to acquire drug giant WXY. To finance the deal, JKL was forced to cut its dividend in half, leaving dividend yield-focused investors with significantly lower returns to anticipate. (To learn more about the potential for this problem, read Is Your Dividend At Risk?)
What to Look For in High Yield
As always, don't rely on dividend yield alone to determine suitable stock candidates. There are other criteria that you need to keep in mind when you invest in high-dividend-yield stocks. First and foremost, look at the stock's history. Companies that have a solid track record of stable or rising dividends payments are preferable. Companies with erratic dividend payment histories cannot be relied upon to provide the safety buffer you are looking for. (Discover the issues that complicate these payouts for investors in Dividend Facts You May Not Know.)
Study the company's dividend payout ratio, calculated as annual dividend per share divided by earnings per share. A high dividend yield combined with a low payout ratio offers a signal that the company has enough room to sustain its dividend when times get tough.
Similarly, scrutinize the company's current and future cash requirements. Companies typically distribute dividends only when they produce surplus cash. But in lean times, less cash might be coming in the door, or the company may require cash for capital expenditure, expansion or mergers and acquisitions, in which case it may be forced to reduce or eliminate its dividends. So, even when looking for stocks with high dividend yields, it's important to make sure that the company can clear other financial hurdles. (For more, read Cash Flow Indicator Ratios: Dividend Payout Ratio and The Power of Dividend Growth.)
The Bottom Line
High-dividend-yield stocks can be a great place to invest in a downturn. For investors looking to protect their capital, a high dividend yield provides a safety buffer in uncertain markets. But remember, companies can start or stop paying dividends at any time, so it's important not to take false security from these kinds of stocks.