“The human body has two ends on it: one to create with and one to sit on. Sometimes people get their ends reversed”. Theodore Roosevelt.
Looking for and obtaining a good rate of return on one’s money has been the holy grail of investing. With historic low interest rates and a wide range of investment products, it can be a challenge to neutralize risk while receiving a good rate of return. I am still waiting for the ETF (exchange-traded-fund) that slices and dices as well as exceeds the performance of the market.
While not as sexy as a hedge fund or as “exciting” as trading penny stocks, investing in companies that pay increasing dividends provides a solid foundation to anchor your portfolio.
- We believe that high quality dividend stocks should be the core of your portfolio. Why?
- Studies have shown that these dividend stocks consistently outperform other stocks over the long-term. Dividend payers account for about 30% of total stock market returns. They provide an increasing stream of income over the years. That’s a pay raise every year!
- They also offer a level of protection versus pure growth stocks in today’s volatile markets.
We put together four key points to help you understand the anatomy of the best dividend paying companies. By following these points, you should be able to spot, select, and grow your dividend portfolio.
The Heart of the Matter – Dividend Growth
The lifeblood of investing in dividend stocks is the growth of the dividend. As with your heart rate, inconsistency can be a sign of a problem. The same holds true when investing in dividend stocks. It is the consistency of the growth of the dividend that is the key point. While the same percentage increase year over year would be great, it is more important that it is raised by a consistent amount each year. Our rule of thumb, look for companies that have a 5–7-year average of raising their dividend by 7-10%. Think of it like this, every year the company gives you a pay raise. For most of us, were lucky to get a 2-3% raise from our employer – especially in this economy.
Muscle vs. Fat – The Payout Ratio
Looking like Hanz and Franz may have its advantages (allowing you to show off your “muscled” body, complete with strained facial expressions chanting “Pump [clap} you up”) but remember, fat is important too. Why? The body converts fats to sugars, when needed, to provide energy. A reserve fund if you will. The same holds true for dividend payouts. Yes, you want income, but not at the expense of exhausting earnings. Simply put – the payout ratio is the percentage of income paid out as a dividend. For example, a company has earnings of $2 and a dividend of $1, thus it has a payout ratio of 50%.
By being aware of a company’s dividend payout ratio, you will avoid purchasing stocks whose yields are too high, and more importantly, unsustainable.
What to avoid?
- Ratios of 75% or higher
- Ratios of 30% or lower
- Inconsistent payout ratios
Owning such stocks usually leads to a lower dividend, followed by a lower stock price and ultimately buyer’s remorse.
We like to look for companies that have a payout ratio of between 40% and 60% – the sweet spot. This provides a nice return to shareholders while retaining enough cash to fund operations, grow the business, and grow the dividend (Pumping [clap] your income up).
Strong Bones and Teeth – A Solid Structure (Business)
Ok, as silly as this may sound, it’s about dividend growth… not the hot new stock or product. While you want capital appreciation, this strategy is all about the dividend…year in and year out. Having already looked at a company’s dividend growth policy and its payout ratio, the third key point is the consistency of the company’s business through the economic cycle. Here is where you want to avoid “fad” products or services and “dying” businesses. While innovative and used at their times, buggy whips, CB radios or Pogo sticks did not stand the test of time. This is where boring is a good thing. We want to own companies that will be able to sell their products 10 years from now at higher prices no matter what the economic cycle.
It’s Only Skin Deep – Don’t Marry Your Stocks
Just like in a personal relationship sometimes things just don’t work out. And yes, breaking up can be hard to do, but usually it turns out to be the right thing. The same holds true when owning a stock.
It’s ok to “like” your stocks, but don’t fall in “love” with them. Emotion combined with money may not break your heart, but it will certainly break your wallet. So be aware of signs that things are changing. For example, earnings are trending down (one missed quarter is ok), but not an overall change in the fundamentals.
Sometimes the market gives you an opportunity to take gains sooner than you had anticipated. While we don’t advocate trading, if a stock has increased substantially in a short period of time (say 40% in 6 months) and you hit the upside target, it makes sense to take some of that profit off the table.
The same holds true on the downside. If a stock falls 20% and the fundamentals are still good, it makes sense to add more to your portfolio. However, if things have gotten worse with the company’s business, sell your position and look for other opportunities. Like our parents said – there really are plenty of fish in the sea.
The Total Package – Conclusion
While not as thorough as Grey’s Anatomy, our anatomical application to dividend investing will certainly allow you to make an informed diagnosis when building your portfolio. The key is having a strategy, the tools and discipline to capitalize on it, and using the end of your body you create with.
That’s the great thing about the market, it always provides opportunities – to buy or sell.
Here is a tool to help you remember the key points. It goes like this…The growth rate is connected to the payout ratio, the payout ratio is connected a solid business, a solid business is connected to higher income… (it’s ok…I am singing it too)!