A craving for juicier returns

Super size me?

The investing world's nutrition cops will tell you differently, but dividend stocks with extra-large yields can be both tasty and good for you.

It's often said that the healthiest approach to dividends is to ignore yield and instead focus on a company's record of increasing the amount of cash paid out quarterly to shareholders. Growing dividends feed share price gains, and they provide a source of income that rises in a way that bonds and term deposits can't match.

High yields are almost like junk food from this perspective. Remember, yields rise when share prices go down. Really high yields mean investors are seriously worried, maybe about the possibility that dividends will be cut or suspended. At best, you would have to say a high-yield dividend stock would offer reduced potential for a dividend increase.

Still, high-yield investing has some appeal. For one thing, you get a return on your dividends that is far higher than anything available from government bonds and guaranteed investment certificates. There's also the possibility that a good stock with a high yield could be a turnaround play.

The idea of focusing on high-yield stocks gained popularity through the Dogs of the Dow strategy, where you buy the 10 highest yielding stocks in the Dow Jones industrial average at the beginning of the year. The dogs strategy was popularized in a 1991 book called Beating the Dow , by Michael O'Higgins.

David Stanley, a retired University of Guelph professor who writes for Canadian MoneySaver magazine, has long followed a similar strategy called Beating the TSX. The concept here is to buy the 10 highest yielding stocks in the Dow Jones Canada Titans 60 index at the end of May.

Now, there's a new approach to high-yield investing that we're going to call the Dogs of the S&P 500 for lack of a better name (feel free to suggest one). You simply buy the two highest-yielding stocks in each of the 10 index sectors, and then rebalance at the beginning of the year.

The story behind this high-yield idea begins with the most recent annual update of the two-minute portfolio, a simple stock-picking strategy of investing in the two largest dividend-paying stocks in each of the 10 sectors that make up the S&P/TSX composite (read it online at: http://tgam.ca/GQV). The deciding factors for the two-minute portfolio are, first, the total value of a company's shares and, second, the fact that it pays a dividend (yield is of no consequence).

Several readers have asked whether the two-minute strategy might be applicable to the U.S. market. To investigate, I contacted CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada. CPMS maintains the two-minute portfolio and agreed to apply the same strategy to the S&P 500.

The result was a 16-year average annual return of 3.6 per cent in Canadian dollar terms, poor enough to prompt CPMS to try a reboot using the two highest yielding stocks in each S&P sector.

This time, the results shone. CPMS has calculated an average total return (price plus dividends) of 8.8 per cent over the past 16 years, compared with 6 per cent for the S&P index. Again, these are Canadian-dollar returns, which reflect the impact of moves in our dollar against the U.S. buck.

The Dogs of the S&P 500 is a twitchy investing strategy, so approach it with caution. In fact, it serves as a warning about the dangers of high-yield investing in general.

Let's start with what happened during the global financial crisis. From May, 2007, through February, 2009, the dogs of the S&P plunged a nasty 55.5 per cent in U.S. dollar terms, compared with 51 per cent for the index itself.

What went wrong? "You could have been buying the most risky stocks," said Jamie Hynes of CPMS. Remember: With a dogs-type strategy, you're buying what investors consider to be damaged goods. Sometimes that's an accurate reading, and sometimes it ignores underlying value.

Jim Steel, president of Polaris Financial in Ottawa, said a high-dividend yield is a signal of an undervalued stock, though not one he would act upon in isolation. He says that one thing you have going for you when you buy a high-yield stock is that companies are very reluctant to cut their dividends.

Back in late 2008 and early 2009, big bank yields rose to the astronomical range of 7 to 11 per cent. "Was that a value opportunity to buy these stocks?" Mr. Steel said. "In hindsight, probably."

But he also cited Manulife Financial as a reason not to become complacent about high-yielding dividend stocks. Manulife halved its dividend last year and its shares are down close to 30 per cent in total over the past three years.

You can keep track of the Dogs of the Dow strategy online at dogsofthedow.com. Last year's results haven't been added to the database yet, but the long-term results up to the end of 2008 are not impressive. The website says the dogs made an average annual 8.1 per cent for the previous 15 years, compared with 9.8 per cent for the entire Dow Jones industrial average. Shorter-term results aren't much better.

Mr. Stanley's Beating the TSX strategy works extremely well. He says that from 1987 through 2009, it averaged a gain of 12.3 per cent, dividends included. The benchmark indexes - they changed over the years - made 9.7 per cent over that period.

High yields can be a sign of trouble in a stock, he said, "but a high yield on good, blue-chip stocks is okay." That's why Mr. Stanley has based his strategy on small indexes of blue-chip stocks. There was the TSE 35 index to start, then the Dow Jones Canada Titans 40 index and then a newer version of the Titans index with 60 stocks.

The highest yielding names in the index for 2010 are BCE at about 5.6 per cent, Canadian Imperial Bank of Commerce at 4.7 per cent, and Bank of Montreal at 4.6 per cent.

Compare that with the highest yields in the Dogs of the S&P strategy: Frontier Communications at 13.4 per cent, Windstream Corp. at 9 per cent and several others at 6 to 7 per cent.

The higher the yield, the higher the risk. Remember that if you're going to super size your approach to dividend investing.

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A three-ring dog show

Three approaches to investing in high-yielding dividend stocks, which are called dogs because it's a falling share price that leads to a high dividend yield.

Dogs of the S&P 500

How to: Pick the two highest-yielding stocks in each of the 10 sectors comprising the S&P 500 index each year.

Origin: Discovered by CPMS, an equity research and portfolio analysis firm.

Long-term returns: 8.8 annually since inception in 1994; compares to 6 for the S&P 500 (all in C$).

Beating the TSX

How to: Pick the 10 highest-yielding shares in the Dow Jones

Canada Titans 60 Index.

Origin: David Stanley, ex-professor and now a contributor to

Canadian MoneySaver.

Long-term returns: 12.3% from 1987 through 2009 with dividends included, compared to 9.7% for its benchmark indexes (they've changed over the years).

Dogs of the Dow

How to: Pick the 10 highest-yield stocks in the Dow Jones Industrial Average every year.

Origin: Popularized by Michael O'Higgins in the 1991 Book, Beating The Dow.

Long-term returns: 8.1 annually for the 15 years to Dec. 31, 2008, compared to 9.8 for the Dow itself.