High Yield Stocks

Who doesn't love high yield stocks? Providing that the payouts are safe and consistent, high yield dividend stocks are hard to beat. As long as the company and its operations remain stable and profitable, all that's required of you is to just sit back and collect your dividends.

Of course, high paying dividend stocks are far from ever being a sure thing. Screen for the 100 highest dividend yielding stocks, and chances are you're going to get back a list of seriously troubled companies, not a list of the best dividend stocks.

Why?

Well, let's take a quick look at the 3 categories of stocks with high dividend yields:

#1 - High Yield Stocks Due to Share Price Decline

If you do screen for the 100 highest dividend yielding stocks, most if not all the results you'll get back will be in this category.

Since current stock dividend yields are calculated by taking the projected annual dividend and dividing it by the current share price, the lower the share price, the higher the yield.

The problem, of course, is that a big drop in the share price of a stock usually indicates that there are some serious issues with the company. And if there are serious issues with the company, how safe is the dividend? Yes, you can find many companies that are reportedly paying 20%, 30%, 40%, and even higher dividends, but in almost all cases it's only a matter of time before the dividend is cut or eliminated altogether.

Tread carefully here and avoid the highest dividend paying stocks. You'll be much better off sticking to solid companies whose shares are temporarily out of favor. The yields on such stocks won't compare to the artificially high yields of struggling and failing companies, but their yields will still rise to attractive levels from time to time.

Legendary Vanguard Windsor Fund manager John Neff generated 20.5% average annual returns from 1964 through 1995 by focusing on quality companies and a low P/E and (relatively) high dividend strategy.

#2 - Natural High Yield Stocks

There are actually a few categories of naturally high paying dividend stocks. The high payout is the result of a specific corporate structure that enables these companies to legally avoid paying any corporate income tax as long as they distribute the bulk (up to 90%) of their earnings to shareholders (or unit holders) in the form of dividends.

These categories are:

Real Estate Investment Trusts (REITs) - REITs typically own and operate properties (industrial, office, or apartment/residential). Earnings come from leasing income. Some REITs are also involved in mortgage portfolios (although not quite as many as there used to be).
Drawbacks to REITs - typically not a lot of fun to own during recessions, when real estate values are declining, or when interest rates are rising.
Master Limited Partnerships (MLPs) - You'll find most MLPs in the energy sector, primarily the oil and gas pipeline areas. For the most part, these are very stable and consistent businesses.
Drawbacks to MLPs - Taxation can be a bit tricky and some MLPs are more directly impacted by energy price fluctuations than other MLPs.
Royalty Trusts (Canadian Royalty Trusts and U.S. Royalty Trusts) - These trusts are also in the energy sector and are primarily oil and natural gas producers.
Canadian Royalty Trusts (CANROYS) are currently in transition. The Canadian government has announced that this form of corporate organization is on its way out. The royalty trusts will convert to regular taxable corporation beginning in 2011.
Drawbacks to Royalty Trusts - High correlation between returns and energy prices; elimination by the Canadian government.
Business Development Companies (BDCs) - BDCs assist smaller companies primarily through financing. BDCs are essentially venture capital or private equity funds that trade publicly and, like the other structures on this list, pay no corporate income taxes.
Drawbacks to BDCs - They usually get hit very hard during recessions since their profitability is dependent upon smaller companies attempting to grow and expand, not a particularly easy task when the economy as a whole is contracting.

#3 - High Yield Stocks:
(Dividend Growth and/or Leveraged Investing)

There's another category of high yield stocks which is often overlooked - "normal" dividend paying stocks that become high dividend stocks later.

For me, this is the absolute, number one, hands down, best way to invest.

If you invest in strong, growing companies with a healthy dividend growth rate, and if you're patient, eventually you'll get a high yield. It's called old fashioned dividend growth investing. How does a 30% annual dividend sound? That's what McDonald's (MCD) investors who were willing to wait 19 years, are getting today.

You can also accelerate this process considerably by employing some conservative option strategies and adopting what I call a Leveraged Investing approach.

Whether you use options or not, the prerequisite is to always, always, always focus on investing in high quality companies and, of course, to recognize the importance of long term investing.