One of the more curious aspects of dividend investing is that some investors slavishly focus on dividend yield above other indicators of a healthy dividend yielding stock. For definitional purposes, dividend yield is ratio derived from: (amount of dividend paid annually/price per share). The higher the dividend yield, the higher the dividend paid relative to its stock price. Thus, a stock paying $1 in dividends and trading at $20/share has a yield of 5% whereas a stock paying $1 and trading at $50/share has a 2% yield. In the abstract, and if you assumed the stock price never goes up, the 5% yield stock is “safer” in the sense you know you are getting a 5% return a year. So, do we always look at dividend yield first when assessing a good dividend paying stock?

I would argue no. The Globe and Mail has been running a series on the best dividend stocks to invest in during 2008. Last week, they listed some of the following as U.S. Dividend Winners: Allstate, Bank of America, Anheuser-Busch, Home-Depot and JnJ. Home Depot was the only stock on this list which is also made the list of this year’s Dogs of the Dow (the Dogs of the Dow is an annual list of stocks who are members of the Dow Jones Industrial Average which has the highest dividend yield as of December 31 of each year).

Why was Home Depot the only stock to make both the analyst list and the Dogs of the Dow? This requires a look at context. If you are like me, and you have a 20-30 year window for investing, chasing the highest dividend yield is not necessarily the best strategy. Remember that dividend yield is a function of both dividend paid and stock price. The issue is that high dividend yield stocks occur in the following situations:

1. The dividend paid is extremely high BUT that means, in most cases, there isn’t much room for dividend increases. If you have a long investment window, you want steady dividend increases since it generally indicates that the business is healthy enough over long period of time to return cash to shareholders.
2. The stock price is, relatively speaking, low which means either the market believes the business is not going to grow that rapidly (remember that a stock price is really a predication of future performance) or the business has suffered a set-back and you may better off investing in a healthier competitor (Citigroup is a good example of this phenomenon; it had a dividend yield of over 7% entering into 2008 based on rapidly declining stock prices; its smaller rival, Wells Fargo (Buffet’s favorite bank) had a lower yield and, arguably, better prospects going forward).

There’s also a larger contextual issue with chasing the highest dividend yield if you have a long investing window. High dividend yield stocks traditionally consist of leaders in mature industries. This year’s Dogs of the Dow consists of members in stodgy and mature businesses like: General Motors, DuPont, AT & T and Altira (a tobacco company). They are under competitive pressures which they have not faced before. I am not sure if the highest dividend yield stocks today will be leaders 10-20 years from now. We are living in an age where massive political and economic change is occurring and we can’t rely upon the industrial leaders from by-gone eras to boast our portfolio.

In a perfect world, my analysis is not to chase dividend yield but to find dividends yielding between 2% -4% in a normal market (I would not rely on dividend yields for financial stocks in this market), with a 5 year annualized dividend growth of 15% and a conservative dividend payout ratio (the % of profits paid out as dividend and written about in my post is my dividend payment safe?). If I had to prioritize these three factors, I would pick the following:

1. 5 year dividend growth: This shows the business is healthy from a cash flow perspective, committed to raising dividends over time and, statistically speaking, the best stocks to invest in relative to their steadier dividend paying peers and non dividend paying stock.
2. Dividend payout ratio: This shows whether the business has room to grow its dividend. Once you have a dividend payout ratio over 50%, there isn’t too much room to grow the dividend payments. This is not desirable if you have a long investment window and are looking for a “raise” every year.
3. Dividend yield: If a dividend yield is high, the stock price is relatively low (which, I readily admit, may present opportunities to engage in value investing) or the dividend payment does not have too much room to increase. I want the happy medium- a growing dividend which can grow year over year and an appreciating stock price.

I wanted to make one final point. Chasing the highest dividend yield is tantamount to investing in bonds on steroids. No one would argue that dividend payments are desirable but extremely high dividend yield stocks (5% plus)  do not appreciate that much relative to its lowest yield counterparts. You create an appreciation ceiling in many respects by investing in too many high dividend yield stocks (having said that, if you can find a stock that has a high yield because the price has been affected negatively in a one-time event, then it may be worth investigating). The point of good dividend stock investing is to benefit from the best of both worlds- cash flow and appreciation. If you chase yield at the expense of increasing dividend payments, you are forgoing appreciation potential.

Do I avoid high dividend yield stock altogether? No. One suggestion I have heard is to anchor your dividend stock portfolio with a high dividend yield stock where the stock appreciation is limited but the dividend is quite secure (typically in a sin industry or utility where profit does not need to be reinvested into the business). Then, invest in several high-fliers- stocks that have increased dividends rapidly over time. The anchor stock mitigates any issues that may result from the high-fliers. I am looking for an anchor now.

As I mentioned, my analysis is contextual to my own situation. For some people with varying risk tolerance, different life circumstances etc., investing in the highest dividend yield stocks may be right for them. As usual do your own due diligence before investing.

Finally, if you want to know more about dividend investing, I would start with the Dividend Guy Blog and Dividend4Life as good resources. Financial Jungle has also constructed a 4.69% dividend yield portfolio for informational purposes.