Here’s an idea: Buy stocks that pay you to own them! They’re called dividend-paying stocks, and if you pick the right stocks, you’ll make money, even if they don’t go up much. Moreover, in a market downdraft, stocks with solid dividend prospects don’t drop as much as other stocks, because when they try, the resulting dividend yield boost attracts more buyers.
What’s yield? It’s the dividends that you receive over 12 months divided by the price that you paid for the shares. For instance, your yield would be 5% if you paid $20 per share for a stock that paid $1 per share in dividends over the following 12 months.
Many banks, utilities, and many manufacturing and service companies pay dividend yields in the 3.5% to 4.5% range, and some pay even more.
Dividend investors often look to tax-advantaged entities such as real estate investment trusts (REITs), Master Limited Partnerships (MLPs) and Business Development Companies (BDCs) for even higher yields. I’ll describe them in future columns.
Your best dividend stocks will be those that raise their dividends while you own them. You win two ways when that happens. The yield on your initial investment goes up with the dividend, and the payout hike usually moves the share price higher. Conversely, a dividend cut shrinks your yield and probably triggers a share price drop as well.
Here are seven simple checks to help you pick the best dividend candidates. Unless otherwise noted, you can find the specified data on Equities.com, as well as on most major financial sites.
1. Dividend Yield
Acceptable dividend yields vary with a firm’s earnings and dividend growth prospects. They require at least 3.0% for growth stocks and 4.0% for utilities and other slow growers. Of course higher is better, as long as the dividend is safe, which leads us to the issue of financial strength.
2. Strong Balance Sheets
Dividend cuts typically happen when heavily indebted companies encounter unforeseen problems and run short of cash to pay their bills. Thus, you can reduce your dividend cut risk by sticking with low-debt firms. The total debt/equity ratio, which compares debt to shareholders equity (assets minus liabilities), is a good debt measure. A zero ratio indicates no debt, and the higher the ratio, the higher the debt. However, in practice, what’s high and what’s low varies by industry. So, rather than a one size fits all rule, simply require that your stocks D/E levels are below their industry average (see reuters.com or money.msn.com for industry ratios).
3. Stay with U.S.
Currently the U.S. economy is the strongest globally, and you can minimize your risk by sticking with U.S.-based stocks that have minimal operations overseas.
4. Avoid Cheap Stocks
Stocks trading below $5 per share get that way because most market players see problems ahead. For dividend investors, minimizing risk is priority number one. Avoid stocks trading below $5 per share.
5. Analyst Ratings
Equities.com and other sites tabulate stock analyst buy/sell ratings into these categories: strong buy, buy, hold, sell, and strong sell. Consider “hold,” “sell,” and “strong sell” ratings as all equating to “sell.” Avoid “hold” or “sell” rated stocks.
6. History Teaches
All else equal, firms with strong dividend growth histories are your best bets for future dividend hikes. You can see a stock’s three-year historical dividend growth rates on Equities.com’s Key Ratios report. Avoid stocks with three-year average annual dividend growth rates below 5%, and higher is better.
7. Earnings Growth
Since earnings growth fuels dividend growth, focus on stocks that analysts expect to grow earnings at least 5% annually. (see reuters.com or money.msn.com for long-term EPS growth forecasts).
You can use your favorite stock screening program to help you pinpoint dividend-payers meeting these seven requirements. To get you started, here are five worth considering:
DTE Energy (DTE) : Electric Utility, 3.2% yield, 6% historical 3-yr dividend growth, 6% expected long-term EPS growth.
Umpqua Holdings (UMPQ) : Regional Bank, 3.5% yield, 35% historical dividend growth, 10% expected EPS growth.
Waddell & Reed Financial (WDR) : Investment Manager, 3.5% yield. 15% 3-yr dividend growth, 14% expected EPS growth.
Dow Chemical (DOW) : Chemical Mfg, 3.6% yield, 29% historical dividend growth, 19% expected EPS growth.
Arlington Asset Investment ($AI): Mortgage Invest, 12.6% yield, 23% historical dividend growth, 10% expected EPS growth.
The seven checks that I described will help you identify dividend-paying candidates worthy of further research. But this is not a buy list. Do your own due diligence. The more you know about your stocks, the better your results.
For more tips and information on how to effectively pick the best dividend stocks, please check out Dividend Detective.