They're two of the best words in the English language…
- Free
- Money
And they're even better when you put them together.
That's pretty much what you get with dividend stocks.
Dividend investments should make up a key part of your asset allocation model, regardless of your personality type.
Why?
Because why wouldn't you want to own companies that have such confidence in their businesses that they commit to paying their shareholders consistent, reliable income per share every quarter in return for investing? It's like free “thank you” money for buying into the company.
Not only that, dividend-yielding stocks historically thrash their non-dividend-paying counterparts over the long term. Indeed, between 1972 and 2017, dividend stocks notched an average 9.25% annual return, compared with just 2.6% for those with no dividend payments, according to Hartford Funds. They also beat the broader S&P 500 annual return of 7.7% over that time.
Yet when many investors think of notching safe, extra income, the typical go-to investments tend to be Treasury bonds, CDs, precious metals, and cash.
But you can do better than that. And dividend stocks can get you there. Here's how to pick the most profitable ones…
How to Pack Your Portfolio With the Best Dividend-Yielders
With around three-quarters of the companies in the S&P 500 paying dividends to their shareholders, you might think it's easy to just stick a few in your portfolio. But there are several key elements to identifying the best ones – particularly in a volatile market, in a time when it's tough to find a decent interest rate.
~ Consistent Demand = Consistent Income
The headline attraction of dividend stocks is the steady income they provide. So a good place to start is by looking for companies that produce critical goods and services – ones that are always in demand, regardless of the economic climate. We're talking about food and drink producers, consumer goods companies, utilities like electricity, gas, and water, plus alcohol and tobacco.
1. Less is More
You might think that the more diversified a company is, the more income it will rake in. While that can be true in some cases (usually at well-capitalized blue-chips), the flip side is that if a firm has many different segments and operations, it will need more infrastructure and capital to keep things running and staffed. That could affect its ability to pay a meaningful dividend . Similarly, there’s a greater chance of more things going wrong, which could eat into its cash intended for dividends.
One of the many words of wisdom from Warren Buffett is to only invest in businesses that you understand. Keep it simple.
2. Cash is King
When it comes to selecting dividend stocks, many investors focus on a company’s sales and income numbers to judge its strength. These are important, of course… but they’re not the most important when gauging dividend worthiness.
Cash is absolutely king here.
Think about it: A company might rake in a ton of great-sounding headline sales. But what if there are refunds later? Or a tiny profit margin? Or a problem that leads to a product recall?
Similarly, profits could be booked, but actual, full payments might come in several installments, or be delayed for another reason. Or sometimes not even paid at all!
Simply put: Sales are not profits. And profits don’t always translate to cash.
But there’s no gray area with cash.
It sounds obvious, but cash is what a company has in the bank and on the books. Period. And it’s cash that goes towards paying dividends .
So look for companies that are cash flow positive. Because if a company isn’t generating new cash flow, it must either tap into existing cash reserves or borrow in order to pay its dividends. Needless to say, that’s not sustainable for long and there’s a risk the dividend could be cut.
Like with individuals, cash is a company’s safety net against adversity or emergencies. There should be enough cash on hand to cover at least two quarters of dividend payments.
But there’s a better way of judging the sustainability of a company’s dividends…
3. Pay Attention to the Payout Ratio
The payout ratio (or dividend payout ratio) is a simple metric that shows the percentage of a company’s earnings that are paid out as dividends. You calculate it by simply dividing annual dividends by annual net income.
For example, if a company notches $1 per share in net income and pays $0.50 per share in dividends, the payout ratio is 50%. So basically half reinvested back into the business and half to shareholders.
In terms of dividend income, you might think that a high payout ratio is better for you. After all, the higher the percentage, the higher the dividend payments. But don’t be fooled. The closer a company’s payout ratio is to 100%, it just shows that it’s paying out a larger proportion of its earnings in dividends. This can be unsustainable .
Instead, look for a number below 75% or 80%. This means the firm isn’t over-extending itself too much and gives a decent cushion for dividends to still be paid comfortably if earnings decline.
The best long-term dividend-payers tend to have payout ratios that remain consistent over many years, as it demonstrates ongoing strength in the business. But consider the industry in which the company operates. Is it one that boasts very consistent, stable income and cash flow over a full year, or more cyclical and prone to ups and downs?
4. Be an Aristocrat
Everyone loves a raise… and these companies are great at them. Shortlist companies have raised their dividend payments for at least 10 years.
Better yet… go for the so-called Dividend Aristocrats – those that have hiked their payouts for an impressive 25 straight years. This demonstrates the management team’s ongoing strength and expertise over many years, with the success to maintain it. The last thing a company wants to do with a dividend is cut it (or eliminate it), as it’s terrible for the share price.
So where do you find and invest in these companies? Well, they all reside in the S&P 500 Dividend Aristocrats Index. And if you want simple, quick exposure to all of them, check out the ProShares S&P Dividend Aristocrats ETF (NYSE: NOBL). The fund tracks the performance of the index and contains household-name companies across a wide span of sectors and industries.
5. Don’t Chase High Yields
When you’re looking for solid, dividend-yielding stocks, the mantra is clear: Don’t chase high yields. While that sounds paradoxical, here’s the deal:
Dividend yield basically tells you the return you’re getting, relative to its share price. The calculation is simple: Annual dividend per share divided by price per share.
So for example, if a stock trades at $20 and its annual dividend per share is $1, the dividend yield would be 5%.
So the higher, the better, right? Not so fast.
A high yield does not necessarily mean a company is going gangbusters. In fact, it should be a red flag. Ask yourself if the company can afford such a payout. If it can’t, it indicates the firm is more interested in just attracting shareholders and chucking dividends at them, rather than investing the money more wisely into the business instead. And there’s a greater subsequent risk of its dividend being cut.
So never base your decision solely on dividend yield, as it won’t tell you anything about the company or its underlying fundamentals.
And since share prices can decline for a number of reasons, a drop might artificially inflate the yield.
For example, let’s say that $20 stock drops to $15, but the dividend per share remains at $1. The yield would rise to 6.6%… but the dividend stays the same. And the stock is now down $5, too. You probably wouldn’t find existing shareholders too giddy about the high yield!
Companies with high dividend yields may be perfectly fine investments… but only if their other metrics are solid, too.
6. Go Long!
While many folks attempt instant gratification from the stock market, investing in solid, reliable, dividend-paying companies offers a “set-it-and-forget-it,” longer-term approach to generating income.
Dividend stocks are proven investments over many decades throughout any market conditions. They thrive during bull markets and supply crucial, consistent income during volatility and downturns.
And if you’re buying stocks anyway, investing in strong, cash-rich dividend-payers also allows you to offset the initial price you pay for the shares. You obviously want the shares to rise, but you’ll collect the income either way. Think of it like buying an investment property and then renting it out.
So don’t let a low-interest, low-yield environment squeeze you. Dividend stocks give you flexibility, income, and reassurance in any market.
