Dividend stocks that pay out regular amounts just for holding their shares aren't just stodgy investments for retirees. These income-producing investments promise regular earnings and lower risk than stocks with better growth prospects, while actually outperforming the broader market.
That's especially true for high-yield dividend stocks that deliver more than 4% of dividend yield, which have a strong track record of outperforming the S&P 500 (SNPINDEX: ^GSPC) over the long term. That's right: Investors looking for the best stocks for long-term growth shouldn't skip dividend stocks. A company with the ability to make a regular dividend payment and even deliver dividend growth can offer better returns than you'll find elsewhere.
Image source: Getty Images.
Whether you're looking for the dividend payment as a source of income or to reinvest and grow your portfolio, the best high-yield dividend stocks could be exactly what you need. This guide will show you what makes a dividend stock qualify as high yield, define important terms for dividend investors, teach you how to identify the best investments, and dive into the top five high-yield dividend stocks for this year.
What is a high-yield dividend stock?
In short, a high-yield dividend stock is one that pays a dividend yield -- a company's annual dividend payments expressed as a percentage of its share price -- that's higher than certain key benchmarks. For instance, the S&P 500, an index that tracks the largest 500 public companies in the U.S., is a common benchmark for the performance of the U.S. stock market, and its component stocks currently have an average dividend yield of 2%. By comparison, any stock paying more than 2% annually would be considered a higher-than-average dividend payer.
However, there's a better benchmark than the average stock: bonds. Investors looking for high yields don't limit themselves to stocks, usually branching into bonds, and particularly federal government bonds, which are constitutionally guaranteed.
A popular holding for investors seeking long-term income known as the 10-year Treasury has historically been used as a benchmark for yield. The 10-year Treasury bond yields 2.64% right now. But with interest rates well below historical averages, even the 10-year Treasury at its current yield isn't necessarily a good benchmark for high yields:
For the purpose of this article, we will define a high-yield dividend stock as one with a yield above 4%, or roughly the yield of a 10-year Treasury in the early part of this century, prior to interest-rate collapse brought on by the 2008 financial crisis.
What terms do dividend investors need to know?
A company's balance sheet lists out its total financial value, calculated by adding up a company's assets, including cash, investments, inventory, real estate, factories, and accounts receivable, and then subtracting all the company's liabilities, including debt, accounts payable and taxes owed.
In short, a strong balance sheet acts as a safety net against unexpected weak business results, provides financial flexibility to act quickly when opportunities arise, or otherwise keeps the company from having to take on high-interest debt to meet its financial obligations. A strong balance sheet signals that management understands the importance of making the most of a company's assets. It also indicates a company's ability to maintain its dividend payment through any economic conditions, reducing the likelihood that the payout will take a cut during a recession or sector downturn.
Cash flow measures how much cash a company generates. There are several different metrics investors use to analyze cash flow, including cash from operations and free cash flows.
Cash from operations (or operating cash flow) is the amount of cash left over after subtracting the cash used to fund operations. This measure is handy because it excludes cash from investments like capital expenditures or sales of assets, and cash from financing. In other words, cash from operations measures the results of whatever it is the company does, excluding one-time charges and nonrecurring events.
Free cash flow subtracts capital expenditures from operating cash flow and is one of the best cash flow metrics to use when looking at a company's ability to support its dividend, since it's essentially the money left over after paying the bills, funding operations, and spending on necessary maintenance and future growth projects.
Payout ratio measures the percentage of a company's GAAP (generally accepted accounting principles) net income required to pay the dividend. Payout ratios vary from one industry to the next -- for instance, real estate investment trusts, or REITs, are required to pay at least 90% of net income in dividends. A good rule of thumb is to invest in companies that don't pay out every dime they bring in, since doing so gives management little room for error if things don't go perfectly.
Cash payout ratio measures the percentage of a company's cash flows it takes to cover the dividend. Specifically, it's a company's cash from operations, minus capital expenditures, divided by the dividend.
Cash flows can be distinctively different from net income, as they indicate the dividend's level of sustainability. For instance, GAAP accounting for net income requires the inclusion of many items that may be noncash when they are recognized. This includes things like depreciation and amortization, which are generally noncash when they are taken, with the money having been spent to acquire the asset being depreciated years prior. This part of GAAP accounting constitutes capital expenditures and necessary future expenditures to maintain or replace those assets when they reach the end of their usable life. Furthermore, taking a depreciation expense is also healthy for cash flows, since it reduces taxable income.
The cash payout ratio especially handy for evaluating REITs. Like all businesses, REITs take depreciation expense for assets they acquire. Here's the rub: Real estate almost always gains in value. By comparison, if a manufacturer spends $1 million on equipment this year that will last for a decade, the investment depreciates over a decade, and then they'll spend more capital to refurbish or replace it. However, if a REIT spends $1 million to buy an apartment building this year, that apartment building will almost certainly be worth more money in a decade. In general terms, real estate typically gains in value on par with inflation, so REITs are depreciating something that continues to be worth more money over time.
So when you combine the fact that real estate tends to gain in value with depreciation as a noncash expense, the GAAP payout ratio doesn't accurately reflect a REIT's ability to meet its dividend obligations. Case in point: Many REITs actually pay more than 100% of their GAAP net income in dividends, while generating cash flows more than sufficient to maintain the payout. Here are three popular REITs to demonstrate this.
The bottom line is, the cash payout ratio is a better tool for REITs and other companies with large real estate assets
There are several other metrics dividend investors should understand that are used to measure specific industries.
Funds from operations (FFO) is a commonly used proxy for net income used by REITs and other real estate-heavy enterprises such as master limited partnerships (MLPs) and publicly traded partnerships. FFO adds depreciation (decline in value of assets) related to these assets back into net income while also adjusting out any gains or losses on asset sales. The result is a more accurate measure of a REIT's or MLP's earnings than the usual GAAP method. This makes it a great tool for both evaluating a REIT's or MLP's ability to maintain its dividend and determining its valuation.
Distributable cash flow starts with net income, adds back in depreciation and amortization, and subtracts capital expenditures. The remainder is what could technically be distributed back to investors. While some MLPs report FFO, distributable cash flow is a better measure since it accounts for capital expenditures on equipment such as pipelines, wind turbines, and other long-lived assets that typically require capital maintenance expenses and will eventually need to be replaced.
The FFO figure doesn't account for those expenses because most REITs don't have direct capital costs related to their existing assets (instead passing them along to tenants), but most MLPs do accrue those costs directly, accounting for this material cash expenditure by using the distributable cash flow number.
How do you find the best high-yield dividend stocks?
When looking for standout dividend stocks, evaluate the company's ability to pay its dividend and its ability to grow that dividend annually.
The ideal dividend-paying company should generate cash flow above and beyond what it needs to invest back into the business, boast a strong balance sheet to help it weather economic weakness or industry downturns, and have a management team with a solid track record of allocating capital to maximize returns.
Image source: Getty Images.
What risks come with high-yield dividend stocks?
Like all stocks, dividend stocks come with the risk of volatility, and recent months have reminded investors that stocks can drop in value for little or no reason, and often quickly and unexpectedly. The S&P 500 fell 20% from October through late December 2018, even as corporate profits remained strong and the economic outlook continued to be relatively robust. Investor uncertainty and a lack of macroeconomic clarity spooked the market, leading to the biggest sell-off in stocks since the 2008 financial crisis. But the market started to recover faster than it dropped, and in the first 15 trading days following the market's bottom on Christmas Eve 2018, the S&P 500 gained more than 11%.
The bond market doesn't move so wildly. Valuing government and investment-grade corporate debt is more straightforward. As a form of debt, there's an easily measured value: the total amount it will be worth when it matures, plus the value of the interest that will be paid. And unless there is fear that a company will become insolvent, the value of its bonds only moves when interest rates change.
Federal U.S. debt is the gold standard for bonds, carrying a constitutional guarantee that it will be repaid. Furthermore, corporate bonds hold more value than stock in the same company, because if a company declares bankruptcy, bondholders are before stockholders in the order of who gets paid first when the company liquidates its assets. Simply put, a company's owners get what's left after all the vendors, lenders like bondholders, and everyone else with a valid claim against the company gets paid.
So, in the short term, stocks carry a risk of being very volatile, especially when the stock market enters a downturn. Too often, investors see the market falling and sell at a loss out of fear. It's important to invest based on your ability to ride out market uncertainty, or else your fears might lead you to sell good companies at a terrible time.
Over the long term, the risk with stocks happens when one invests in a struggling company. The potential repercussions include being forced to cut (or even eliminate) the dividend payment, and in the worst-case scenario, file for bankruptcy. These risks can lead to real and permanent losses if a company's results worsen, and you sell.
Rewards can more than make up for the risks
If you're comfortable riding out short-term market drops, and you own a diverse portfolio of companies to offset the occasional -- and, frankly, unavoidable -- bad stock pick, the rewards of owning high-quality high-yield stocks should more than offset the risks.
The best high-yield dividend stocks are great companies with a proven track record of growing earnings and rewarding long-term investors with decades of steady dividend growth and stock price appreciation. Unlike a bond, which is generally worth about what you paid for it when it matures, stock prices usually increase over time.
Furthermore, as long as a company continues performing well, you won't have to do anything outside of holding the stock and getting paid. When a bond matures, you must start over by identifying the next bond to buy. When you invest in a mutual fund that continually invests in bonds, you'll trade a portion of your yield to pay the fund managers.
High-yield stocks can reward long-term investors with both dividend growth, and capital appreciation that far exceeds what investors could capture with even the highest-yield investment-grade bonds. Investors of any age or financial situation can benefit and should consider dedicating a portion of their portfolio to dividend-paying stocks.
Top five high-yield dividend stocks for 2019
|Hospitality Properties Trust (NASDAQ: HPT)||7.88%|
|Ford Motor Company (NYSE: F)||6.83%|
|Brookfield Renewable Partners LP (NYSE: BEP)||6.54%|
|AT&T Inc. (NYSE: T)||6.47%|
|Brookfield Infrastructure Partners L.P. (NYSE: BIP)||4.70%|
Dividend yields as of Feb. 27, 2019.
Let's take a closer look at all five of these companies.
The top risk-reward high-yield dividend stock
Most REITs sign their tenants to long-term triple-net leases of 10 years or more, which include property taxes, building maintenance, and building insurance. This combination of predictable and secured revenue is a big draw for dividend investors, since it means less volatility when the stock market swings wildly, while also providing a higher yield than bonds.
But hotel REITs like Hospitality Properties Trust have substantially more exposure to economic swings. Vacations are one of the first things people give up when money is tight, which means fewer hotel guests. Meanwhile, Hospitality Partners has taken on more debt over the past year, and rising interest rates have caused investors to fear a scenario in which the company is faced with both rising interest expenses and falling hotel occupancy -- a legitimate concern.
This could be an overstated risk, though, as management has been using the debt to improve its hotels, and is in the midst of an ongoing renovation project that should pay off with more customers and higher room rates over time. Furthermore, the company already has about two-thirds of the cash it needs to complete the remodels, and will likely be able to fund the rest with the cash it generates. Moreover, most of the hotels it owns operate in the mid-market space, which attracts business travelers, who are less impacted than vacationers by a pained economy. This should help it maintain adequate cash flows, even during a trying time for hotel owners.
Further reducing its risk, Hospitality is not just a hotel owner, deriving one-third of its cash flows from roadside travel centers under the TravelCenters of America and Petro brands. These assets generate steady cash flows during most economic conditions, offsetting the downside risk if the hotel business experiences weakness.
Lastly, its dividend is more secure than Wall Street seems to be treating it, and should be strong enough to ride out a modest economic downturn quite easily. For instance, the company has paid out only about two-thirds of cash flows in dividends in recent quarters, even as renovations reduce incoming revenue and weaken nightly rates, while managing a small dividend increase.
Investors willing to buy and hold Hospitality Properties Trust through any potential ups and downs should do incredibly well.
Recent weakness makes AT&T a strong high-yield holding
The last few years haven't smiled on shareholders of Ma Bell. The company's stock lost 30% of its value since 2016 while the company made several ill-advised acquisitions including DirecTV and Time Warner, taking on nearly 50% more debt to fund those deals:
DirecTV is bleeding users, and it seems AT&T won't see anything like the return management initially promised from the deal. The company will try to maximize the value of the library of content it bought as part of Time Warner, a deal unlikely to generate the returns it promised Wall Street to secure the funding.
And while those bad deals have added debt and wiped out wealth for people who bought AT&T back in 2016, it has created an excellent opportunity for today's investors looking for good value and a high yield. Trading for 8.7 times estimates for 2019 EPS and yielding 6.5%, AT&T is a deep value, and its high yield gives it a very low bar of earnings growth to deliver double-digit annual total returns.
Furthermore, the company paid out more than 75% of cash flows in dividends once in the past decade, while delivering dividend growth every single year:
AT&T checks all the boxes high-yield investors should seek: high yield, great value, stable cash flows, and dividend growth.
Uncertainty with a massive margin of safety for Ford
Ford's turnaround has been ongoing for multiple years, under several CEOs. While there has been marginal progress, the company hasn't gotten where it promised to be, and Wall Street has punished it early and often.
While the overall stock market delivered investors positive returns in four of the past five years, Ford gave investors losses in four of the past five years:
Throw in preliminary 2018 results that show another down year, and management's decision to break from its usual pattern of issuing full-year guidance for 2019, and Wall Street is more negative on Ford's prospects for the coming year than it has been in quite some time.
The company's efforts to refocus on hybrid and electric vehicles will take more time and a lot more money to complete, but it's still worth a close look for investors seeking a high-yield dividend payment. Even while the auto business has entered a slowdown and Ford has seen Chinese and European business struggle, the company only paid out 40% of cash flows to cover its dividend over the past year:
Additionally, Ford retains a substantial cash position on its balance sheet, ensuring it can maintain its base dividend, which yields an impressive 6.8%, should auto sales further deteriorate.
The auto business can be wickedly cyclical, meaning Ford can't count on steady cash flows like AT&T does. But Ford's combination of a solidly profitable business and plenty of cash can bridge the gap when things get bad, and its dividend makes it a high-yield stock worth owning.
Two high-yield sister stocks for every dividend investor's portfolio
Brookfield Infrastructure and Brookfield Renewable Partners are closely related businesses, as their names make abundantly clear. Part of the Brookfield Asset Management collection of entities, these two incredibly well-managed sister enterprises offer investors fantastic ways to gain exposure to two important and growing areas of global demand: energy production and critical infrastructure.
Brookfield Infrastructure owns assets around the world including water, natural gas, and electricity distribution systems, toll roads, sea ports, and telecommunications assets. Many are regulated local monopolies, and in almost every case they face very high barriers to competitive entry. Furthermore, these kinds of assets are critically necessary to modern life and generate rock-solid cash flows across every economic environment.
And with some of the best people in the business calling the shots, Brookfield Infrastructure has proven one of the best dividend stocks investors could have owned since going public:
Brookfield Infrastructure's cash flows slipped slightly in 2018, but not because its individual assets struggled. Brookfield's executives have proven quite adept at capital allocation, including selling off low-growth, lower-return assets and then redeploying the proceeds into higher-growth, higher-return assets.
The catch is that sometimes it takes management some time to identify the proper assets to redeploy that capital into and 2018 was one of those periods where management remained disciplined, refusing to rush into buying anything just for the sake of it. That took a bite out of 2018's results, but historically, this disciplined process has resulted in market-beating returns in the long run.
And now that the company has reinvested the $1.3 billion in proceeds from its asset sales into assets that generate much higher returns, investors who buy Brookfield Asset Management today should be well rewarded with many years of dependable dividend growth.
It's been a similar -- if slightly lesser -- experience for long-term Brookfield Renewable investors:
While its corporate cousin owns a variety of infrastructure assets, Brookfield Renewable invests in and owns a collection of hydroelectric, solar and wind energy-producing facilities, which has allowed it to steadily and regularly deliver dividend growth over the past decade.
Its stock price has also fallen significantly over the past year. Even after a pretty solid jump since late in December 2018, its share price is down 16% from the high, while its dividend yield reached its highest levels since 2016.
The reason behind its falling price is simple: Cash flows were weaker in 2018 than the prior year, primarily due to disappointing results from its massive hydroelectric segment. More than three-fourths of Brookfield Renewable's cash flows come from hydroelectric power production, and after enjoying a banner year in 2017, lower rainfall in 2018 meant less power to sell from its biggest segment.
However, Brookfield Renewable's future is heavily built on its ongoing investments in wind and solar. Between its controlling stake in TerraForm Power (from which it collects a double-digit dividend return) and growing the size of its wind and solar production assets, Brookfield Renewable is taking advantage of the falling costs to produce power from wind and solar and the huge growth prospects for clean power.
Following the same method of disciplined capital allocation that's focused on generating the best long-term returns and growth, Brookfield Renewable is an ideal high-yield stock that investors should look to own for as long as possible. And since Wall Street has spent the past year caught up in the short-term results and bidding its stock price down, investors looking to buy today have a solid opportunity to buy at a solid discount to its usual valuation, then enjoy that 7% yield for many years to come.
Make dividends an important part of your investment strategy
Whether you're still 20 years from retirement or already there, dividend stocks can make for a key part of your portfolio. Think about it this way: The stocks described above all have substantial dividend yields, large margins of safety to maintain those payouts, and solid opportunities to increase the size of the dividend they pay in the years ahead.
For wealth builders, those high yields can really pay off during stock market sell-offs or extended periods of low returns, while investors looking for income can count on those high yields across any market condition. So whether it's dependable income or portfolio growth you're after, high-quality, high-yield stocks like these five can help you reach your investing goals.
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Jason Hall owns shares of Brookfield Infrastructure Partners, Brookfield Renewable Energy Partners, Ford, and TerraForm Power. The Motley Fool owns shares of Brookfield Asset Management. The Motley Fool recommends Brookfield Infrastructure Partners and Ford. The Motley Fool has a disclosure policy.