Using Dividend Yield To Spot Bargains

One of the favourites indicators used by investors to spot bargains is the dividend yield.

Dividends are cash paid to shareholders for their ownership of a (successful) business. When stock prices are down, it means you’re paying less to own this cash flow.

A dividend yield of 10% means that you’re paying 100p to obtain an annual dividend of 10p. In just a decade, you will recoup all your initial outlay (assuming dividends stay at 10p). And you still get to own the shares – for free.

Where in the world could you own such bargains right now? Places where ‘mass fear’ permeates, such as the UK.

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Brexit, as one astute investor observed, contains ‘dreadful outcomes that cannot be ruled out.’ But you can be sure that the same investors would be watching UK assets like a hawk, waiting patiently to snap up bargains if Brexit leads to a market crash. You can bargain hunt like them too.

Incredible Yields In Some Large UK Stocks Now

Using the latest Sunday Times Top 200 Companies (February 17, 2018), I ranked firms with the highest headline dividend yield. This simple exercise gave me some familiar names like Persimmon (yield 9.8%), Vodafone (9.6%), Royal Mail (8.6%), BATS (6.9%), Shell A (6%) etc (see below).

If these yields are paid out over the next few years, these shares offer huge value. According to AJ Bell, FTSE 100 firms are projected to pay out a record £93.7 billion over the next twelve months!

But Brexit is upending British businesses. Factories are closing, firms relocating their HQs. Some sectors are simply collapsing (eg, retail). So, in reality, some companies may not be able to continuing paying shareholders this much. In other words, some of these high dividend yields are unsustainable. They could, in investment parlance, be a ‘value trap’.

However, smart investors also follow a golden rule: Diversify.

Not all firms will experience the same cash flow squeeze. British American Tobacco’s business model is distinctly different to that of Centrica or Aviva. Persimmon has little foreign exposure; in contrast Glaxo has a huge international business.

Moreover, if you own them in ISA accounts (£20k per annum max), these yields are tax-free.

Stocks With Highest Headline Dividend Yield (%)

  1. Into Prop – 11.9%
  2. Standard Life Aberdeen – 10.4%
  3. Persimmon – 9.8%
  4. Vodafone – 9.6%
  5. Centrica – 8.7%
  6. Royal Mail – 8.6%
  7. SSE – 7.9%
  8. William Hill – 7.6%
  9. IG Group – 7.2%
  10. TUI – 7.2
  11. WPP – 7.1%
  12. British American Tobacco – 6.9%
  13. Phoenix Group Holdings – 6.8%
  14. BT – 6.7%
  15. Hammerson – 6.7%
  16. Imperial Brands – 6.6%
  17. Marks & Spencer – 6.6%
  18. Aviva – 6.5%
  19. Shell A – 6%
  20. ITV – 5.9%
  21. HSBC – 5.8%
  22. Direct Line Insurance – 5.8%
  23. Capita – 5.8%
  24. Man – 5.8%
  25. Legal & General – 5.8%
  26. BP – 5.7%
  27. Greene King – 5.5%
  28. Babcock International – 5.3%

To derive a list of high yielders, you start by answering the following simple questions.

Five Questions To Ask When Looking At Dividend Yields

  1. How certain is the dividend stream? Rank the firm’s business model -> High/Med/Low.
  2. Is the firm profitable? If the firm is making losses, is it temporary?
  3. Is the whole sector down or just that stock?
  4. Is the firm borrowing to pay the dividends or it comes from the firm’s free cash flow? Choose the latter.
  5. Is the stock prices basing? Make sure the technicals look right.

Once you have these answers, you should have a list of contenders. Next, use the following principles to construct a portfolio, perhaps equal weight each investment.

Three Principles To Follow For Dividend Yield Investing

  1. Diversify – Buy a portfolio of stocks in different sectors/market capitalisation/earnings geography. This lowers the risk.
  2. Best-In-Class – Do not just look at headline dividend yields. Find the best stock in that sector that offers a good yield. They may pay less but could be financially stronger. During the 2008 crisis, Warren Buffett did not buy indiscriminately. He bought only the best (Goldman, GE, etc)
  3. Timing – Buy when the market is very fearful. This way, you are paying less to own the company.

Finally, remember to think long-term, ignore short-term price fluctuation, and try to avoid following the crowd. For example, if you had ignore the mass fear in December 2018 and bought some stocks, you could be sitting on profits now. Always remember John Templeton’s words: “If you want to have a better performance than the crowd, you must do things differently from the crowd.”   

Best Brokers for Dividend Yield investing

To compare all brokers for dividend yield investing see our stock broker comparison table. Or you can read more about these top three brokers

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