Long term investors rest easy at night when they know that their portfolio is based on solid dividend-paying stocks with a long track record of increasing earnings and dividends. Returning profits to shareholders is what all established companies should do. The best companies make dividend growth and distributions a priority.
I have seen many different dividend investment strategies put into use by investors at all levels. Some focus only on dividend growth, others prefer the highest yielding portfolio possible and others are more concerned with total return. Each investor knows what is best for them.
There are over 1,000 stocks that yield 2% ore more trading on the NYSE, NASDAQ and AMEX. This post will review a few of the most common strategies and discuss how to use each strategy to pick dividend stocks.
Method 1: My Method – HPR System
I use the HPR system to develop the best dividend stock list each month. My primary concerns are yield and dividend growth and that is where I always start. Stocks that have recently cut dividend distribution or that have yields below 2% are usually not something I’ll spend time reviewing. The next thing I care about is the safety of the dividend. This can be measured using many different metrics including cash flow, free cash flow yield, payout ratio, net income, expected net income growth, debt, future risks to the business and developing competitive advantages.
To get a quick look cash flow and income I like to use the free cash flow yield and payout ratio metrics because they tell me what percentage of cash flow a company is paying out in yield (free cash flow yield) and what percentage of earnings a company is returning to shareholders (payout ratio).
I also care about what the stock’s performance has been. A slow and steady climb higher always makes my heart feel warm but if a stock has had a recent drop or sudden increase its very important to understand why. These market reactions are just that, reactions, which means something happened to make the market move the stock.
Now just because a dividend stock has performed well over the last 12 months does not mean that its a great time to buy it. This could be considered one of the flaws of the HPR Rating I developed except this rating system is meant rank stocks based on their fundamentals and historical performance. It’s not meant to be a buy list or predict the future.
That being said I do use the HPR ranking system to help me identify my next investment because it uses all of the items I listed above and gives special weight to yield and dividend growth. In general I start off ranking dividend stocks by the following numbers:
Yield: 2% minimum, 3% is better, 4%+ is best
Dividend Growth: 3% minimum, 5% is better, 7%+ is best
Free Cash Flow Yield: The higher this number is above the dividend yield the better – Minimum 1% or more depending on how high the yield is
Income Growth Rate: 5% is minimum, 10% is best
Payout Ratio: 80% is generally as high as I’ll go, 62% or lower is the best
12 Month Return: The higher the better for historical ranking. I’m more concerned with proper valuation than stock performance when considering buying a stock. While this is used in the HPR rating its taken with a grain of salt when I analyze a stock for my portfolio.
Side note: REITs cannot be evaluated on these same metrics. You can see what I look for in REITs here.
Determining Fair Value
History tells us where a stock has been but it does not tell us where its going. There are many factors that go into determining fair value for a stock and I won’t get into the details of each one here. One metric I use is the average dividend yield. I look at the average yield over 5 year history to help me determine if a stock is overbought or oversold. The idea being that if a stock has averaged a 3% dividend yield for 5 years and it now has a 2% dividend yield it may be overbought. There are many reasons why this could happen so its important to determine why the yield is above or below its average.
Averages are nice but they are also just a starting point. Other items I consider before adding a stock to my portfolio include the following:
- Sector valuation
- Balance sheet
- Earnings expectations
- Dividend growth expectations
- Competitive advantage to grow the business
Some of these items can be determined by your gut instincts but most are hard numbers that require careful examination.
Method 2: Dividend Growers and That’s It!
The safe dividend list is a list of companies that have increased dividends for 20 consecutive years. This is no small feat of course. I am constantly hearing about people who will invest in any stock on this list just because it is a Dividend Aristocrat. These investors are usually new and inexperienced to buying dividend stocks.
The three biggest factors they overlook:
1. Many of these stocks have low yields (under 2%)
2. Although the company has increased its dividend for 25+ consecutive years the dividend growth rate is very low
3. Future net income could be very low which will inhibit growth and total return
Stocks with consecutive dividend increases are a great place to start looking for your next dividend investment but it’s just a starting point.
Method 3: Index and Fund Investing
I have nothing against Index investing or putting money into Mutual Funds. In fact I have created an entire page dedicated to funds that pay dividends monthly. When you use this strategy you are of course at the mercy of whoever is running the fund. It’s hard to stay on top of the changes they make or understand why they are shifting in an out of a stock. These funds do provide a decent level of diversification and for many busy investors it can be the best way to go.
Here are a few funds and ETFs that have a majority of their holdings in dividend-paying stocks.
Vanguard Dividend Growth Fund
S&P 500 High Quality Fund
SPDR S&P Dividend ETF
WisdomTree Dividend Top 100 Fund
PowerShares S&P 500 High Dividend Portfolio