Diving for Dividends? Look Beyond Yield Alone

This week marks the one-year anniversary of stocks' rebound. And any time you see a market move like this one, it's worthwhile to pause and consider what lessons you've learned. One clear takeaway--albeit not a particularly earth-shattering one--is that retirees can and should have stocks in their portfolios. And because many retirees also look to their portfolios for current yield, dividend-paying stocks provide a good convergence of both income and long-term capital appreciation potential.

Granted, dividend yields aren't particularly high for the broad market right now--currently about 1.7%. But dividend-paying stocks offer a few key advantages for retirees, provided you stay attuned to their potential for volatility and don't use them to supplant your entire fixed-income portfolio. While stocks in aggregate aren't all that cheap right now, they very likely offer better long-term appreciation potential than bonds. (Roger Ibbotson laid out that point effectively at the recent Morningstar Ibbotson conference.) The tax treatment of dividend yields is also better than what bonds provide, at least currently and potentially in the future, as well. And while stocks wouldn't be impervious in the face of a big jump-up in interest rates, the negative fallout might not be as direct as bonds might face.

So assuming you're a retiree on the hunt for dividend-paying stocks and funds, where do you start? The following screen can help turn up some investments worthy of future research.

One important point is that whether you're looking for stocks, funds, or exchange-traded funds, screening on yields alone doesn't cut it, and that's true for both stocks and bonds. The key reason is that there's often a connection between yield and risk, and a very high dividend yield can be a clue that a company is in distress. (Just ask the many holders of financials stocks during 2008, who saw yields jump up even as their companies' stock prices were plummeting.) A company's dividend yield is calculated by dividing its annual dividend per share by its price per share, and when the denominator (the price) drops, the yield spikes up.

So for the purpose of my screen for good dividend-paying mutual funds for retiree portfolios, I used our  Premium Fund Screener to focus on nonspecialty stock funds with 12-month trailing yields of 2.5% or more. That, at least, can help identify funds for which dividend payers are a core part of the strategy.

But to help weed out funds that are investing in high-risk, down-and-out companies, I screened on those funds with below-average standard deviations relative to their category peers. My thinking was that if a dividend-focused fund were taking undue risks, it would've shown up in 2008 and therefore would be captured in a high three-year standard deviation.

I also screened out funds with 10% of their assets in bonds or securities we categorize as "other," usually convertibles and preferred stocks. There's nothing inherently wrong with those funds, but my goal of the screen was to find stock-centric funds with strong dividend yields.

I also focused on funds with low costs relative to their category peers'. Expenses are important no matter what you're doing, but especially when you're focused on yield. That's because fund expenses come right out of yield, and if a fund has high costs, the costs are liable to gobble up almost all of the payout.

To further refine the search, I looked for managers who had been on the job for three years or more. I also focused on distinct portfolios (to screen out the gobbledygook of multiple share classes) and no-load funds that aren't exclusively available to institutional clients. (If you'd like to include advisor-sold funds in your search--and there are several advisor-sold funds that fit all of the other criteria I've laid out above--simply omit the "no-load" screen.) Premium users can click  here to run the screen themselves and to see the seven funds that cleared our screen as of March 9, 2010.

That screen turns up a compact list of seven fund names, some familiar, some less so. One of my favorites that clears the aforementioned screen is  Vanguard Equity-Income (VEIPX), an actively managed fund whose low expense ratio consistently provides it with one of the higher dividend yields in its large-value category.

If you're focusing on dividend-paying stocks or exchange-traded funds, you can run screens along these lines using the  Premium Stock Screener or ETF screener. For example, you could screen for stocks that have trailing-12-month dividends yields higher than 2.5%, wide or narrow economic moat ratings, and star ratings of 4 stars or better. My colleague Josh Peters also does a terrific job of highlighting low-risk, high-quality dividend payers in his newsletter, Morningstar DividendInvestor. 

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