The Clearest Signal of All

You've got a life to lead. Rather than actively managing your investments, I'd bet you'd prefer to spend time with your family and friends, doing almost anything else. Yet if you don't take care of your money, it'll never grow to the point where it can truly let you focus on those far more important things.

It's a tough quandary, really. Spend too much time with your money, and you'll miss out on enjoying the things that it can provide. Ignore your finances, on the other hand, and you won't have the money to spend on those things in the first place. Clearly, balance is key, and striking the right balance will let you have both the money and the time to enjoy your life. Isn't that your ultimate goal?

Keep it simple
This is a primary reason why a dividend-focused investing strategy is so very attractive. Companies that pay dividends to their owners do so for two key reasons. The first is to directly reward them for the financial risks they have taken by investing in the company. The second -- slightly more subtle but equally important reason -- is to signal the likely future for the business.

By paying attention to the signals that dividends send, you can greatly simplify your investing research. Three key questions about a company's dividends will help you cut through the clutter:

  1. Are they still there?
  2. Are they sustainable?
  3. Are they growing reasonably?

If you like the answers to those questions, then you may have a very low maintenance -- and profitable -- investment on your hands. And to answer them, all you have to do is check a company's yield, payout ratio, and year-over-year dividend growth. This table shows how straightforward that investigation can be.

Company

Yield

Payout
Ratio

Year-Over-Year
Dividend Growth

Allstate (NYSE: ALL  )

2.2%

18%

10.5%

3M (NYSE: MMM  )

2.3%

40%

11.1%

Citigroup (NYSE: C  )

3.9%

41%

11.4%

General Electric (NYSE: GE  )

2.8%

58%

13.6%

Johnson & Johnson (NYSE: JNJ  )

2.3%

38%

14.6%

Freddie Mac (NYSE: FRE  )

2.7%

54%

39.3%

McDonald's (NYSE: MCD  )

2.4%

29%

49.3%

Question being answered

#1

#2

#3

Data courtesy of Yahoo! Finance.

By my personal rules of thumb, any yield of at least 2% is acceptable, any payout ratio below 67% is tolerable, and dividend growth should outpace inflation. If an ordinarily strong company in my portfolio falls outside of those ranges, it gets put on the warning list. If either further investigation reveals big problems or within about a year it shows no sign of improvement, it becomes a candidate for being sold.

Why it works
A company's dividend policy tells you volumes about what the business really expects for its future. Because of the bad press and extremely negative market reaction to a dividend cut, companies don't like to cut that payment if it's at all possible. On the flip side, the magnitude of a dividend increase can really reveal how confident a company's management is in its business plan. After all, since nobody wants the bad press of cutting a dividend, a company will typically only raise its payment if it's pretty certain it can make the higher payout.

As a result, you can often better determine the real truth about a business from its dividend practices than from virtually any other statement or financial report. That's the signaling power of a strong dividend policy, and it's why Motley Fool Income Investor has managed to solidly beat the market since inception.

If you're ready to cut through the clutter and pay attention to what really counts, then Income Investor is for you. Click here to get started down your path of straightforward investing success with your 30-day free trial.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric and Johnson & Johnson. Johnson & Johnson is an Income Investor recommendation. 3M is an Inside Value selection. The Fool has a disclosure policy.


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