5 Steps to Buy a Reliable High-Yield Dividend Share

Level 6 of the DIY Income Investor Income Pyramid consists of high-yield shares in a High Yield Portfolio (HYP). For more experienced investors this will be a key tool in hopefully gaining income and capital growth.

Today we'll look in more detail at how to identify a suitable HYP share in 5 easy steps.

1) Make Sure You Are Ready

We have place building a HYP at Level 6 because it is a relatively sophisticated investment strategy. Our suggestion for relatively new investors is to:

• make sure you have enough cash and accessible savings to cover any foreseeable expenses you may have
• initially only risk a small proportion of your total savings in a HYP (this is probably what would happen anyway, as most people don't have huge amounts of money to invest)
• be happy with taking the risk involved
• make sure you have worked your way up the levels of the Income Pyramid - think about investing initially in an ETF that targets high-yield dividend shares, to get the hang of the approach (and you can watch what shares are included in the ETF) - such as the iShares FTSE UK Dividend Plus (IUKD)

2) Be Prepared to Diversify

No matter how good a stock picker you think you are, or whether you follow the guidance below to the letter, there is still a risk that one or two of your choices could go pear-shaped. So you need to diversify - it is a High Yield Portfolio.

On the other hand, there is no point in owning too many different shares - academic work has shown that beyond about 20 different shares, your portfolio will not significantly reduce risk; what is more, it will begin to behave like an index and therefore lose its high-yield 'edge'.

You can diversify by:

• buying shares in different market sectors (in other words, no more than one bank share, insurance share, oil share, etc.
• hold no more than 10% of your portfolio in any one company: if the share price of one of your holdings rises significantly, you may need to reduce your holding

In your early investment in a HYP, if your budget is limited you may be better off in an ETF targeting HYP shares - this will give you as much diversification as you need.

3) Decide on What Makes a Good HYP Share

Experience - and academic research - has helped to define the characteristics of a successful HYP share:

• Dividend yield is high but not too high: although not all companies pay dividends, many do - but we want our money to work hard. We are looking for high-yield dividend shares that will provide consisent dividends - not companies that are heading for trouble. One reason why a share can have a high dividend yield is if the share price has fallen a lot - possibly because the company is in trouble. Although companies that pay dividends don't like to frighten the market by reducing or even cancelling the dividends, sometimes they don't have any choice!
• Enough cash to pay the dividend comfortably: Looking forward we also don't want to get involved with companies that are spending too much of their cash flow on paying dividends (implying that they may not be able to maintain them)
• Large enough to be financially stable: Smaller companies may pay attractive dividends - but they may be knocked off course by a relatively small market shock - it is better to concentrate on larger companies, such as those in the FTSE 100 (although even these largest companies are not immune from problems - with examples such as Lloyds or BP)
• Not have a lot of debt: When trouble strikes and cash flow is reduced, a company with high debt repayments has much less chance of retaining dividend payments. With utility companies, you may allow higher levels of debt, as these companies make fairly predictable profits, and they take on debt to maximise the return to shareholders - so one or two such highly-geared utility companies can be allowed into a portfolio
• A track record of increasing dividends: companies that have a long history of dividend payments, increasing over time, will usually manage its affairs conservatively enough to be able to retain dividend payments
• Good value: we don't want to overpay, so we want good value for money, in terms of the earning power of the share (which will help to pay the future dividends)compared to the price of the share
• Lack of bad news: information about things going wrong in a company is sometimes slow to reach the market; there is an old saying that bad news comes in threes - meaning that company management often don't initially see the whole problem when they announce bad news

Many of these characteristics can be picked up from the analysis of company financial results.

4) Use a Stock Screener and Apply HYP 'Filters'

Picking out shares by the particular characteristics of their financial results is called 'screening'. There are many different types of 'screen', depending on what type of share you are looking for.

There are a number of online resources that provide a share screening function that will simplify your HYP share selection process. This process screens the financial data of companies using a number of 'filters' which help to eliminate companies that are not likely to be suitable

I particularly like the comprehensive screener offered by Digital Look (this is free - but you must register with them). There is a pre-set 'popular' 'High Yield' screen; this currently (early April 2011) gives a list of 52 stocks - but will need to edit this to home in on the 'best buys'. You do this by clicking on the link 'to refine your search criteria click here'. You can then add more restrictions to the choice of potential HYP shares.

The filters we can use are based on the HYP share characteristics identified above:

• Only shares from large companies (e.g. FTSE 100) - say capital value of more than £1 billion
• Dividend yield: historic and forecast - more than 4% and no more than around 7-8%
• Average dividend yield for the last 5 years - more than 2-3% (assuming that it has been increasing)
• Dividend cover at least 1.5 and preferably 2
• Price/earnings ratio: less than 15
• Net debt: look for no more than around 50% - 75%

For other factors, such as dividend growth history and 'lack of bad stories', you will have to do a bit of research on your own.

If you add all these filters to the current Digital Look screen, you may find no companies will be selected - you can start with the unedited 'High Yield' screen and gradually filter it through to find the most promising HYP candidates.

The results of a recent 'Pick of the 5% Club' is shown in a previous post.

5) Buy Your Shares in a Tax-Exempt Online Brokerage Account

Paying tax on dividends and capital growth can really take the shine off your HYP investment - so make sure you use a tax-exempt brokerage account to minimise your tax liability.

An online brokerage account will allow you to easily check up on your investments - although, in theory, you won't have to do this very ofter, as they will be generally 'buy and hold' investments.

Other HYP Share Selection Approaches

One of the clearest online exponents of the high yield approach is The Motley Fool‘s writer Stephen Bland (‘TMFPyad’), Bland initially proposed the high yield approach to retirees seeking a better-value alternative to annuities.

The Monevator blog also provides an excellent 4-part guide to selecting shares for a UK-based HYP, using a very similar approach: Part 1; Part 2; Part 3; Part 4.

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.