Dividend Yield, Explained: Why I'm Holding High-Yield Stocks My Conviction Ratings Flag as "Strong Buys"

Dividend yield equals the annualized dividend divided by the stock price. It is one of the easier financial metrics to calculate and understand. But the dividend and the dividend yield can tell you much more than just what income you can expect from an investment. In fact, the dividend and dividend yield are core components of my investment approach, helping me identify high-conviction opportunities such as Procter & Gamble (NYSE: PG), Federal Realty (NYSE: FRT), and Enbridge (NYSE: ENB).

Using dividends to identify high conviction investment ideas

Before getting to dividend yield, I usually start with the dividend alone. Or, more precisely, a company's dividend history. It requires a strong and growing business to support a dividend that is regularly increased. So, a dividend history that is filled with annual increases is solid evidence that a company is worth owning.

Image source: Getty Images.

I normally start by only considering companies that have at least 10 annual dividend increases. But ideally, I prefer longer dividend streaks, with many of my investments falling into the Dividend King grouping, which indicates at least 50 annual dividend increases. Procter & Gamble and Federal Realty are both Dividend Kings, while Enbridge has increased its dividend for 31 years, in Canadian dollars.

That said, a great company can be a bad investment if you pay too much for it, as Benjamin Graham famously said (Graham helped train Warren Buffett of Berkshire Hathaway (NYSE: BRKA)(NYSE: BRKB) fame). Luckily, you can also use dividends to assess valuation.

The simple math of a dividend yield tells you how much income you'll generate from an investment. However, dividends tend to be more consistent over time than earnings. And stocks tend to trade within yield ranges. When a company I'm interested in has a historically high yield, I believe it indicates a good entry price. I added P&G, Federal Realty, and Enbridge to my portfolio when they were trading at historically high yields.

Sticking it out for the long term

This isn't a foolproof method for selecting stocks. Even Dividend Kings cut their dividends occasionally. So you have to dig into each stock you are considering buying to understand the story you are investing in. Sometimes, a high yield indicates that a business is deeply troubled. But I've found that dividends and dividend yield have consistently identified great opportunities for me.

For example, when Dividend King Procter & Gamble underwent a business overhaul a few years ago, its stock fell sharply. The consumer staples giant's plan was to sell smaller, less profitable brands so the company could focus on its largest and most profitable ones. That sounded like a good move to me, and I jumped on the opportunity to buy the stock while the yield was historically high (and high relative to the market, as well). I'm not selling anytime soon.

Federal Realty is the only real estate investment trust (REIT) that is a Dividend King. It owns strip malls and mixed-use developments in high-density locations with wealthy populations. I had long admired the business, but the REIT is usually afforded a premium price. I kept it on my wish list, just in case. During the coronavirus pandemic, I had the opportunity to buy it when investors were acting as if people would never shop again. I have no plans to sell this REIT icon.

Enbridge is a giant North American midstream company that also owns regulated natural gas utilities and clean energy assets. It generates reliable fee-driven cash flows that support an attractive yield. The Canadian company's goal is to supply the world with the energy it needs, leading management to slowly adjust its portfolio mix beyond pipelines and carbon-based fuels. During the pandemic, when oil prices cratered, Enbridge's stock sold off even though energy prices aren't a major factor in its financial results. The volume of energy that flows through its system is the bigger determinant of success. With a historically high yield, I bought Enbridge, and I haven't looked back.

Dividend Yield: Easy to explain, but more powerful than you think

My biggest investment successes have been driven by analyzing dividends and dividend yields. If you are patient, you can use dividends to build a portfolio of high-yield stocks backed by great businesses. In fact, P&G's roughly 3% yield is fairly attractive again, amid concerns about consumer spending and inflation. I have no doubt the company will survive the headwinds, and I've been considering adding to my position.

Enbridge's 5.5% yield is also attractive, though it has been higher in the past. If you are looking for energy exposure but don't like the idea of commodity risk, it is worth a deep dive today.

Federal Realty's 3.8% yield is high on an absolute level and might interest conservative dividend investors. But most should probably keep it on their wish list. A yield closer to 5% would be much more enticing. A recession could give you the opportunity to buy, even though the Dividend King has easily survived many recessions over the last 50 years. And it highlights the importance of keeping a list of great dividend stocks on hand so you are prepared to act when the timing is right.

Reuben Gregg Brewer has positions in Enbridge, Federal Realty Investment Trust, and Procter & Gamble. The Motley Fool has positions in and recommends Berkshire Hathaway and Enbridge. The Motley Fool has a disclosure policy.