How to use StockRanks to find high-yield stocks
In the first part of this series, we looked at how investors can use the StockRanks to help find reliable dividend growth shares.
In part two, we’re going to turn our focus onto high dividend yield stocks. For investors who want to maximise the cash income from their portfolio, high yield stocks can be a good choice.
The UK market tends to be relatively well supplied with income stocks, thanks in part to its heavy weighting to large financials and natural resources stocks (although high yields may be available in other sectors, too).
What’s high yield?
Let’s start by defining what we mean by high yield, in a stock market context.
Rather than setting a numerical threshold, we feel it makes more sense to define high yield relative to the wider market average. This allows for varying market conditions and provides some useful context when considering the yield on individual shares.
For UK investors, we’d use the FTSE 100 average yield as a benchmark for the market, as this is generally the highest-yielding index in the UK. You can find the current average yield for the index on our FTSE 100 page.
We’d suggest a benchmark for high yield as being c.50% above the FTSE 100 average. The index typically yields around 4%, so this might suggest a threshold of around 6%.
What should investors expect from high-yield dividend stocks?
If you’re looking at a stock with a high dividend yield, it’s worth asking why the yield is so high.
While there are no hard rules on this, our experience is that most high-yielding stocks fall into one of three categories:
Mature, slow growing and highly cash generative. Generous dividends are sustainable because growth opportunities and capex requirements are limited. Tobacco stocks are the classic example in the UK market.
Cyclical stocks that are out of favour (and cheap) or that are enjoying a period of bumper earnings that may not be sustainable. Financials, housebuilders, and natural resources stocks might be typical examples. Earnings cover, cash generation and balance sheet strength will influence whether the payout will be sustainable through the bottom of the cycle.
So-called ‘yield traps’ – these may appear in almost any sector of the market. The high yield is a warning that the market expects the payout to be cut. The company may be trading poorly or facing other problems. Such investments are often best viewed as turnaround or contrarian stocks, rather than as income plays.
Correctly categorising high-yield stocks is not always easy. In addition, companies quite often fall into more than one of these categories at various times.
In the remainder of this guide, we’ll look at how you can use the StockRanks and some simple screening metrics to help you find high-yield stocks with sustainable dividends.
Finding good high-yield stocks
The StockRanks are designed to highlight shares that offer an attractive mixture of value, quality and momentum. Of course, this doesn’t necessarily mean they will offer above-average income – for many companies, generous dividends aren't appropriate or even possible.
To find shares with the potential to offer a reliable high yield, we’d suggest using a combination of the StockRanks and some simple screening metrics. By doing this, we can create a more manageable and targeted list of stocks for further research.
Saving screens such as this in your account makes it easy to check regularly for new opportunities that merit further investigation.
Market Capitalisation > £100m: we've specified a minimum size because micro-cap stocks with high yields are generally specialist investments requiring additional research. For a general high yield portfolio, we believe larger stocks are more likely to deliver suitable results. Even £100m is still very small, but there are some good quality small-cap dividend shares on the UK market.
StockRank >60: since the inception of the StockRanks in 2013, shares with StockRanks of 60 or higher have collectively outperformed the FTSE All-Share index (April ‘24/view latest performance data here).
ValueRank >50: a high-yield share should generally trade on modest valuation ratios. If it doesn’t, then it may be a special situation or some other unusual scenario requiring in-depth understanding.
Dividend yield (rolling) > 1.4x market average: this measure narrows down our stock selection to shares with a dividend yield at least 40% higher than the market average. Experimenting with different values here may be useful – reducing this multiple provides a larger and more diverse range of stocks to consider.
Dividend cover (rolling 1y) > 0.8: this measure compares forecast earnings for the next 12 months with the expected dividend payout.
For non-financial companies we would normally look for earnings cover to be greater than one, but for some financial and property stocks this isn’t always necessary – we comment on this in more detail below.
As always with a screen, it's important not to be too restrictive. Screen results are an initial short list, not a final selection.
Financial & property stocks: reported earnings from companies such as life insurers and property companies can be distorted by non-cash gains and losses relating to investments held by the business.
As a result, the historic earnings that appear in the StockReports may not provide a meaningful guide to the past affordability of dividends. To really understand how past dividends were funded, it may be necessary to take a look at previous years' accounts.
Life insurers tend to report a measure of surplus cash generation. This is generally a decent proxy for dividend affordability, although it may also be needed to repay debt.
For property companies and REITs, EPRA earnings can be a good guide to affordability as this industry measure reflects profits generated from rental activities, and excludes gains and losses related to property revaluations.
Fortunately, broker forecast earnings for these businesses are generally calculated on an adjusted basis that reflects expected dividend payment capacity. This is why we've used the one-year rolling forecast to test for dividend cover by earnings.
Next steps
Generating a high dividend yield from a diversified portfolio of shares can be a good way to produce attractive levels of income from a share portfolio.
However, it’s important to remember that dividends are never guaranteed and can always be cut or suspended. This is a particular consideration where companies carry significant levels of debt, the repayment of which must always be prioritised ahead of dividends.
To mitigate the risk of dividend cuts, we’d always suggest running a diversified portfolio with a reasonable number of shares – perhaps 20-25.
Taking this approach should reduce the impact of any individual dividend cuts that may occur. A more diverse portfolio should also provide more stable year-on-year payouts than a more concentrated portfolio.
For investors focused solely on reliable income, it may be worth considering lower-risk options such as corporate bond funds or UK government debt (gilts).
However, the additional risk of owning dividend stocks does carry some potential reward. Most successful companies aim to deliver earnings growth that’s at least in line with inflation, over long periods.
All else being equal, this should translate into dividend growth and share price gains over time. Thus, the total return available from a dividend portfolio may be greater than that available from lower-risk alternatives such as corporate bonds and gilts.