How to hunt for top quality high yield shares

In the search for dividend income there are strategies to suit all tastes - whether you’re after long-term payout growth or the very highest forecast yields. In terms of price returns, dividend strategies tracked by Stockopedia held up pretty well in last year’s flat market conditions. Most generated positive single-figure returns and the yields on offer generally improved. But this year things have changed dramatically. Some of these income strategies are racing ahead, and the top performer so far is Quality Income - up an eye-catching 17%. So what is a quality income share, and how can you find one?

Being realistic about yields

Quality Income looks for large, high quality companies in strong financial shape, which offer good - but not excessive - yields.

It’s an approach inspired by the quant global equity team at investment bank Societe Generale. They developed a quality income index back in 2012 after finding that that chasing the very highest forecast yields tends to end in disappointment. It turned out that the very highest yields were often attached to companies that were likely to have to cut their dividends in the near future. These yields are often fantasy and the shares become known as dividend traps. Very recent research by advisory firm Research Affiliates arrives at much the same conclusion.

Examples abound, but one high profile dividend yield trap last year was Tesco. Twelve months ago Tesco’s forecast yield was a whisker off 5%. But a collapse in earnings forced a swingeing dividend cut last summer. It left the yield on the shares limping along at just over half a percent.

What Tesco showed was that a sparkling dividend history and high yield is no gauge of the future. What’s more important is sound balance sheet health and good business economics. As such, Stockopedia’s Quality Income strategy requires stocks to have a modest forecast yield of more than 4%.

Looking for quality economics

To get a picture of financial strength, Quality Income uses American finance professor Joseph Piotroski’s F-Score. Companies must pass more than seven out of a possible nine of Piotroski's accounting tests to qualify for the strategy. The checklist is backward looking insomuch that it looks for improving trends in financial statements. These touch on a company’s profitability, debt, liquidity, share dilution and operating efficiency.

Quality control is also measured using another accounting checklist called the Altman Z-Score of bankruptcy risk. This combines five ratios that are designed to show how closely a company resembles others that have filed for bankruptcy.

Both the Piotroski F-Score and Altman Z-Score are components of Stockopedia’s overarching assessment of a firm’s quality, called the QualityRank. You can screen for the highest ranking QualityRank stocks using the menu in the StockRanks portal.

In this case, we Duplicated the existing Quality Income screen and used the Table Editor to include the QualityRank of each company on the list. This means we can see a much more detailed insight into the quality of each stock. Subscribers can see the customised screen here.

The median yield here is 4.5%. That’s lower than the average 6.2% on offer from stocks on the yield-focused Forecast Dividend Dogs strategy. But the companies have generally much stronger QualityRanks. Leading the list in terms of quality is fashion retailer Next and housebuilder Persimmon, which are both highly profitable, improving businesses that are popular among income investors.

Indeed, the roaring price performance of housebuilders in recent years hasn’t dented the sector’s high yield attraction, with Taylor Wimpey and Galiford Try joining Persimmon on forecast yields of 5.5% and 4.5% respectively.    

In third place is Dragon Oil, which is currently considering a takeover bid from the Emirates National Oil Company. This is interesting because the bid has forced up the price of shares in Dragon over the past month and trimmed back the forecast yield to 4.1% from 5.1%. If the bid were to fail, the yield may bounce back - possibly making it one to watch.

Among the sin stocks is tobacco firm Imperial Tobacco, on a forecast yield of 4.7%, and bookmaker Ladbrokes, which offers the highest yield on the list at 5.8%.

An interesting point about this list is that, with further investigation, the four companies with QualityRanks of less than 80 - Glencore, SSE, Kier and Ladbrokes - all have potentially concerning levels of dividend cover. Cover of less than 1x means that all earnings are being distributed as dividends. Ultimately, that can be problematic to the point of forcing a dividend cut. It’s worth noting though, that all four are forecast to see dividend cover rise above 1x in 2015.

Quality is paying off

In the search for dividend stocks, high yield is obviously one of the most important considerations for investors. Yet, sparkling headline yields can mask question marks about a business and ultimately flag the potential for a dividend cut. With Quality Income, the strategy stacks the odds against disaster by stripping away the emphasis on excessive yields and balancing it with financial quality. It’s an approach that’s certainly found a sweet spot in the UK market so far in 2015. We’ll be reviewing the performance of all the income strategies when the portfolios are rebalanced at the end of June.

Don’t forget, if you want to read more about dividend investing, you can download our free ebook - How to Make Money in Dividend Stocks.If you aren’t yet a site member get started at Stockopedia here.