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Dividends: S&P's 7% Club

From Standard & Poor's Equity Research

The average dividend yield on the Standard & Poor's 500 stock index is 1.9%. For longer-term investors counting on both capital appreciation and accumulated dividends over a multiyear period, that historically small percentage may not be a big deal. But income investors may find it just a little bit skimpy.

With those people in mind, we decided to journey to the the land of high dividend-yield stocks, an exotic locale populated by lesser-known names and a gaggle of real estate investment trusts. It's a far riskier place than the relatively safe confines of the big-cap, big-name neighborhood, but it does present some interesting choices for the yield-hungry.

Before we got to the yield part, we wanted to make sure the stocks we selected were attractive based on one S&P measure of their fundamentals. Our first filter utilized S&P's Fair Value model, which calculates a stock's weekly Fair Value—the price at which it should trade at current market levels—based on fundamental data such as corporate earnings and growth potential, price-to-book value, return on equity, and current yield relative to the S&P 500. Stocks are ranked from 5, indicating significant undervaluation, to 1, indicating significant overvaluation. We sifted for those stocks ranked 5 (significantly undervalued) or 4 (somewhat undervalued).

RISK TERRITORY. Okay, now for the yield part. From the 4 and 5 Fair Value list, we looked for those issues with a dividend yield greater than 7%, which is more than three times the yield on the S&P 500 index.

In addition, these stocks have a dividend payout ratio (dividends as a percentage of earnings) of less than 70%—which means that there should be cash to support this dividend yield going forward.

That said, we think it's important to note that piling up on stocks with dividend yields far larger than the market average carries risks. It's generally harder for companies to maintain such high yields over time. And of course, companies can choose to suspend or cancel dividends at any time.

When we finished our search, four names emerged:

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