The best place to look for high yields

You can't get away from share prices.

They are in the newspapers, online and on your mobile phone. Every night, the news will tell you what the closing level of the FTSE 100 or the Dow Jones Industrial Average was.

Of course,price matters - overpaying for a stock is a sure way to lose money.

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But overly obsessing about share prices is a bad habit too. It's understandable if you are a day trader, but if you are looking to share ownership as a route to long-term wealth it's not a good idea.

One little known FTSE index demonstrates why.

Dividends are just as important as capital gains

How often have you heard a financial expert say that share prices have gone nowhere for over a decade? From a capital gains point of view, it's undeniably true.

The level of the FTSE 100 is still 18% below its peak achieved in December 1999, as you can see from the blue line on the chart below.

FTSE 100 v FTSE 100 Total Return Index

But what about all the dividends that have been paid since then? You don't hear about the FTSE 100 Total Return Index much. Its value takes into account dividends paid by companies and assumes that they are reinvested back into the shares that they came from.

This index (the purple line on the chart above) is now back at an all-time high. Since December 1999, it has increased in value by 27% - significantly outperforming the FTSE 100 price index.

A return of 27% over nearly 13 years is still miserable. You need to do a lot better than this if you are going to meet your financial goals. Government bonds and gold have done much better. But looking at the total return index reinforces a valuable lesson for investors.

Share prices could go sideways for years to come

Firstly, it shows that passively investing in an index is not always a no-brainer'. If you buy an index when it's historically expensive, you can expect poor returns in the future.

Secondly, and more importantly, it highlights the benefits of reinvesting and compounding dividends over time. We are big fans of this approach to equity investing. The hard part is finding the right stocks to buy in the first place.

Let's face it, the prospect of a fresh bull market in stocks looks fanciful at the moment. Interest rates are at rock bottom levels while high rates of earnings growth look unlikely given a weakening global economy.

The last bull market in stocks started with double-digit government bond yieldsand stocks trading on single-digit price/earning (PE) ratios. We are a long way from this scenario.

As a result, the dividend compounding approach looks like it will be one of the few decent ways to make money from shares for the foreseeable future.

As I've written before, buying good companies with high and sustainable dividend yields and reinvesting the dividends can allow you to build up a decent savings pot providing you are prepared to invest for a long time.

The beauty of this approach is that you spend less time stressing about share prices. Instead you focus on the quality of the underlying business and its ability to keep paying you dividends. This makes it a strategy for stock pickers rather than buying the market.

But are dividend stocks overvalued now?

The one problem is that lots of people are finally cottoning on to this. The mad scramble for yield has made dividend stocks very popular, as the fresh record high for the FTSE 100 Total Return index demonstrates.

Throw in the fact that lots of investment strategists and financial experts are talking about dividend stocks and the importance of income, and you get the feeling that it's becoming a crowded trade.

The word "bubble" is often overused. All I'd say is that compared to a few weeks ago, there are fewer high-yield candidates to choose from.

If I look down the list of FTSE 100 stocks, only 12 have a historic dividend yield of over 5%. Of those 12, perhaps only Vodafone has a business model and level of dividend cover that gives you some confidence that its payout can withstand a major economic storm.

Some investors are beginning to look at overseas markets for high yielding stocks. This isn't a bad idea European stocks are among the few generally cheap markets, and we've been tipping them recentlyin MoneyWeek magazine.

There are plenty of chunky yields on offer particularly in the utility and telecoms sectors. Do bear in mind the withholding tax on foreign dividends and currency risks though.

The FTSE 250 may be a happier hunting ground for dividends

If you'd rather stick with the London Stock Exchange, then whether you are looking for decent high-yield stocks or just cheap companies, it's often better to look at smaller companies.

They get less attention than the big blue chips and not as many analysts cover them. You therefore stand a better chance of getting a bigger bang for your buck.

The FTSE 250 still has some big companies and tends to be more exposed to the UK economy. But that doesn't mean you can't find some decent dividend paying stocks here.

For example, Dairy Crest (DCG)yields nearly 6% and has a virtually debt-free balance sheet after the disposal of its St Hubert's spread business. Also, in MoneyWeek magazine, I've recently written about a pub operator and brewer that looks worth buying, and believe it or not an attractive property company. If you're not already a subscriber to MoneyWeek, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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