How to find winning high-yield shares

In a recent article, I looked at evidence supporting the idea that strong, reliable dividend growth could be a predictor of a stock’s multibagger potential.

The only problem with this approach as an income strategy is that the yields on offer from such shares tend to be low, at least when purchased and for several years after.

For example, a dividend that rises by 10% per year will take around seven years to double. So an investor buying such a share with a 2.5% yield will have to wait seven years to achieve a 5% yield on their purchase cost – assuming nothing goes wrong in the meantime.

This means that dividend growth stocks may not be ideal for investors seeking an upfront income, perhaps to supplement a pension.

To address this issue, Alex and I have switched things around this week and shifted our focus to higher yield shares.

Using Stockopedia’s historical data, we believe we’ve found some useful factor traits that may help investors identify winning high yield shares – in other words, stocks with the potential to provide stable or rising income and positive capital returns.

How we did it

For our purposes, we’ve defined high yield as the top quartile of the UK market.

In the data set we’ve used, this corresponds to a minimum yield of 3.5% and a median yield of 6%. After excluding some anomalies, the upper end of this yield range is around 10%

Looking at this in context, I think it’s also a logical and relevant yield range for income investors to consider:

• The average yield of the FTSE 100 is typically 3.5% to 4%;

• Savers and gilt investors can readily get 4% or more, with no risk to their capital.

In the remainder of this article I’ll share our findings on factor-based high yield investing.

For clarity, here’s an outline of the data set we used:

• We used UK share data from 2014-24;

• Only companies that were listed and paid a dividend throughout that period were included;

• Minimum market cap £10m.

Lower yields generate better price returns

High yielders do not always provide the strongest share price performance. They’re often more mature businesses with slower growth profiles.

In addition, they may be offering high yields because they are out of favour and perhaps not trading very well.

Perhaps unsurprisingly, low-yielding shares have provided stronger price returns for most of the last 10 years:

Note: the low yield band in this chart and elsewhere in this piece represents the bottom quartile by yield of our UK market data set.

Higher yields generate better total returns (but only sometimes…)

As income yields rise, it’s logical that dividend payouts start to form a greater part of an investor’s total return. This is true whether income is reinvested or withdrawn.

Any comparison of returns from dividend-paying stocks needs to include income, as well as price gains.

When we consider total return, the comparison between high yield and low yield becomes more nuanced. High yielders are ahead on a 10-year view, thanks to a strong run since 2022:

I’ll return to this topic shortly. But first, let’s take a look at the fundamentals behind dividend yields.

Factor exposure is often weaker in high yield stocks

The StockRanks are largely income agnostic, but dividend yield is a component of the ValueRank. That makes sense, as high-yield investing is a traditional value strategy.

However, while dividends don’t feature directly in the QualityRank or MomentumRank algorithms, this doesn’t mean that the factor scores are not relevant for income investors.

What we’ve found is that the factor ranks remain very relevant as a predictor of reliable dividends.

This correlation is quite logical when we start to think about some of the fundamental metrics behind the QVM factor ranks.

QualityRank: in recent years, many quality stocks have sported valuations that have kept their yields low. But the fundamental factors that define quality are also key ingredients in a reliable dividend.

For example, adequate profitability is essential to support a sustainable payout and a stable book values:

Strong free cash flow relative to debt is another useful measure. Cash generation should ideally leave headroom for debt reduction as well as the dividend:

ValueRank: we have often written in these pages that pursuing a single factor strategy is likely to produce less consistent returns.

Stocks with very high ValueRanks may offer a high yield, but there’s likely a reason for this.

Some may be bona fide high income opportunities that are naturally slow growing. But others may be yield traps offering a promise that will ultimately be unfulfilled.

Yield traps are stocks with high yields that are no longer supported by the fundamentals. The end result of holding a yield trap stock is usually a capital loss and a dividend cut. The likelihood of this outcome is clear in the chart below:

Most income investors have been caught out by yield traps at some point. Finding ways to avoid these tempting but costly stocks more successfully was one of my key motivators for this piece.

MomentumRank: in the chart above, we see momentum scores dropping steeply for the highest-yielding shares.

This reinforces the point above about yield traps – the best way to avoid these situations is probably to focus on stocks with an element of positive momentum.

There will always be exceptions to this rule. But in my experience, showing some respect for momentum is a sensible policy, even for income investors.

What do the best high yield stocks look like?

It turns out that we can use the StockRanks to create a clear profile for the high yield stocks that are collectively most likely to deliver superior returns:

I was a little surprised by this chart when Alex first shared it with me. High QM rank is a profile I associate with High Flyers. I would not instinctively use it to describe a quality high yield share.

On reflection though, the failure of imagination is all mine! Looking at yield stocks in this way makes a lot of sense. As I’ve discussed already, elements of quality and momentum are key to supporting stable capital values and above-average income.

In a follow-up article in the coming weeks I will explore this actionable insight in more detail, with an example screen to highlight potential winning high yield stocks.

I’ve already been experimenting with some screening rules and I can say that I’ve been surprised by the breadth and depth of choice available.

However, for now I want to leave you with an interesting chart that takes a slightly different perspective on high yield returns.

To everything there is a season?

If I pick only stocks that tick the boxes for winning high yield, can I expect to consistently outperform the market?

Probably not.

Past performance is no guarantee of future results. But total returns from UK stocks over the last decade suggests that as with all other strategies, high yield outperforms sometimes and underperforms at others:

I always hesitate to make any kind of macroeconomic observations. I’m no economist and much of this stuff is above my paygrade. But I can’t help drawing some linkage between rising interest rates and the outperformance of higher yield UK stocks.

Why might this be?

All stocks are equally weighted in our data set. That means this isn’t a direct analogy with the FTSE 100 outperformance we’ve seen since 2022, where a number of the largest stocks have driven this market cap-weighted index higher.

However, one possibility that does seem plausible to me is that the apparent correlation with interest rates is actually a second-order effect. If we think back to the end of 2021, many small and mid-cap companies with strong exposure to the UK economy were trading at demanding multiples (with low dividend yields).

A lot of those companies have underperformed over the last couple of years, as they’ve been hit by sluggish consumer demand, inflation and rising finance costs.

In contrast, traditional high yielders in sectors such as banking, insurance, oil and defence have benefited from or been indifferent to higher rates. Some have delivered outstanding returns over this time.

However, I’m sure there are other, better explanations than this – so please, let me know what you think in the comments below.

What happens next? Rightly or wrongly, my feeling is that after a decade of freakishly low interest rates, western markets are still adapting to a more normal cost of capital.

I don’t know how the next phase of this adjustment will go. But we’re now living in a world where inflation and interest rates are more elevated and volatile than they’ve been for much of the last decade.

Against this backdrop, I think that investing in good quality dividend stocks with positive momentum could be a logical strategy for investors with a need for income.