The evidence seems to suggest that by buying the highest yielding stocks you’re chances of outperforming the wider market are significantly improved. However, the evidence suggests that it’s not dividend yield, but dividend cover that is the key factor investors need to look out for when hunting for the best long-term dividend plays.
In an equity research paper entitled High Yield, Low Payout, Credit Suisse Group AG (ADR) (NYSE:CS) analysts Pankaj N. Patel, Souheang Yao and Heath Barefoot found that highest yield stocks were not the overall leaders in terms of return. The analysts ran a simulation of a dividend strategy from January 1980 to June 2006 using a universe of stocks within the S&P 500 and created equal-weighted declie baskets based on dividend yields.
Over 26-year period studied; they found a direct correlation between low payout ratios and higher returns within the higher dividend yield universe. To take a deeper look at this trend they created three dividend yield baskets ranked by yield; i.e., high yield, low yield, and no yield. Then, within each of these baskets they categorized stocks based on payout ratio; i.e., high, medium and low. Equal-weighted portfolios of these baskets were created based on dividend yields and payout ratios as of each quarter-end for the period January 1990 to June 2006. The high yield, low payout portfolio bucket generated an annualized return for the period of 19.2% versus 11.2% for the S&P 500. On the other hand, the high dividend yield, high payout ratio bucket produced an annualized return of only 11.0%, underperforming the S&P 500.