Five steps to finding a high-yield stock

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Unfashionable in raging bull markets and not immune from the big bears, picking quality high-yield stocks is something of a Holy Grail of investing.

It works because though the long-term average annual return from equities is reckoned to be in the region of 6.5% in real terms, if most of this can be captured in the form of dividend yield, the market can comfortably supply the little that is needed on top.

In addition, the advantage of higher-yielding equities is that, in some cases at least, dividends can grow. Pick a time when yields are relatively high, and gains can accrue from the market, from a trend to lower yields, from the cumulative dividend payments, and from dividend growth.

Dividend investing like this does not work in all phases of the market cycle. High-yielders go out of fashion in rampant bull markets. And they are far from immune to the negative influences present in bear markets. Just ask shareholders in BP (BP.) and Cable and Wireless Worldwide (CW.), both seemingly secure high-yielders who put through sizeable dividend cuts.

The high return generated consistently by most high-yield stocks does not come without risks attached, as these examples show. But the compound effect of a high yield over time, if it is reinvested, has a powerful effect. A 7% yield, reinvested each year, will result in a doubling in capital over 10 years. There are dozens of high-yield stocks in the wider market, some riskier than others.

The knack is ignoring the risky ones and picking the safe bets. The biggest risk in high-yield investing is that the dividend is cut. High-yield investing requires a bit of detective work to establish those where such an eventuality is unlikely.

So what should you look for, and what are the rules to follow?

1. A super-high yield should be treated with wariness. This needs to be judged relative to the market. If the yield on a share is, say, 2.5 times the yield on the wider market, questions need to be raised. A share yielding 8.5% when the market yields 3.5% might suggest caution. Super-high and double-figure yields often suggest a possible, or even imminent and likely, dividend cut.

2. A high yielder with a stable business is a better bet than a company with a cyclical one. For this reason investors often prefer utilities to many other companies when it comes to picking reliable high-yield stocks. Not only is demand for their products stable, but their businesses are regulated and their profits more predictable than most.

Better still, find a company with a stable business that is growing - however unfashionable the industry might seem. Some of the best high-yield plays in recent years have been found in tobacco companies, for instance.

3. Look at dividend cover. This is the number of times the dividend is covered by earnings per share. This is the traditional shorthand way of selecting high-yield stocks, balancing yield with dividend cover. Cover in excess of two times gives a margin of safety adequate for most businesses, but this criterion could be relaxed if the business has a rock-solid history of stability.

Remember, though, that profits can be manipulated, so it's worth checking that the profit figure is an 'honest' one, by checking cash flow numbers as well. Operating profit numbers significantly higher than operating cash flow hoist a red flag over the P&L account. There may be a simple explanation, but it needs checking out.

4. Look at cash and debt. Dividend cuts cause a stink. It is therefore a move that company managements take only very reluctantly.

Looking at the cost of the dividend in the context of the scale of the company's borrowings, its interest bill, and any cash in the balance sheet helps to put this in perspective. A chunky interest bill will always trump dividends to shareholders. A company cannot stay in business if it fails to pay the interest on its borrowings. But if borrowings are low or the company has sizeable cash balances in reserve, the chances of a dividend cut are remote.

5. Check the firm's dividend policy. While it generally pays to look at what companies do rather than what they say, any explicit official commitment to pursue a particular dividend policy reinforces the reliability of a company's yield.

Utilities are often in a good position to do this, as their revenue and profits are frequently linked to the RPI or CPI, and therefore they can commit to dividend increases at or above the rate of inflation. A high yield, with a stated dividend policy of providing dividend increases 1% or 2% above the rate of inflation, is an attractive package for investors.