Dividend stocks aren't as exciting as high-growth stocks, but buying and holding them can generate big returns for patient investors. But with the market hovering near historic highs and interest rates set to rise, investors should be very picky about dividend stocks. Here are eight simple tips that can help you zero in on the ideal income plays for your portfolio.
1. Don't simply chase high yields. While it's nice to have a high yield, chasing high yields can cause you to overlook issues that could cause the dividend to be cut or suspended. It can also lead you to unfamiliar companies in unfamiliar sectors, which leads me to my next point --
2. Don't invest in sectors you don't understand. My worst investment last year was shipping container company Textainer (NYSE:TGH). I was attracted to the company's low valuations and high dividend yield (over 6% at the time), but I didn't consider that the cyclical shipping container market was stuck in a brutal decline due to the global glut of containers, cheap steel, and an economic slowdown in China. Those factors caused Textainer to slash its dividend twice, and the stock tanked.
3. Check the payout ratios first. Instead of simply looking at a stock's yield, investors should check the dividend as a percentage of a company's earnings and free cash flow to determine if its payouts are sustainable. For example, Casino giant Las Vegas Sands (NYSE:LVS) spent 137% of its earnings and 126% of its free cash flow on dividends over the past 12 months -- indicating that it might need to cut its 5.1% yield in the near future.
4. Compare its valuations to its industry peers. Many dividend stocks rallied over the past few years due to a low interest rate environment making bond yields less attractive. But as interest rates and bond yields rise, many investors will start trading in their income stocks -- particularly the ones which have loftier valuations -- for bonds. Tobacco giant Altria (NYSE:MO) was a favorite safe haven play in that market, but it now trades at 26 times earnings -- which is much higher than the industry average of 21.
5. Look for steady earnings and free cash flow growth. If a company consistently grows both figures, it can consistently pay its dividends. But if both are dropping through the floor, a dividend cut might be in the cards. Las Vegas Sands, for example, paid out $2.9 billion in dividends over the past 12 months. Compare that figure to its wobbly net income and FCF growth over the past three years to see how unreliable its dividend actually is:
6. Check its record of dividend hikes. Companies that want to promote their stocks as income investments will often hike their dividends every year. Companies that do this for over 25 years become elite "dividend aristocrats" like AT&T (NYSE:T), which has raised its dividend annually for over three decades. These types of companies are unlikely to suspend or slash their dividends -- even at the nadir of a global financial meltdown.
7. Reinvest your dividends with a DRIP (dividend reinvestment plan). Investors who don't need to spend their dividend income right away should enroll their stocks in a DRIP -- which automatically uses the payments to buy additional shares of the stock at a slight discount to the market price. Doing so has three advantages -- the purchase is commission-free, it averages out the purchase price over time, and the compounding effect allows you to automatically grow your position.
8. Remember your effective yield. When a stock rallies and the yield drops, investors often sell the stock to buy one with a higher yield. In that situation, the investor has likely forgotten his or her "effective" yield -- the percentage the stock actually yields based on the principal price.
For example, AT&T currently has a forward yield of 4.8%. But my average purchase price for AT&T is $33.74, which gives me an "effective" forward yield of 5.8%. Therefore, I should think long and hard before trading my shares of AT&T for a stock with a 6% yield.
The key takeaway
There's no perfect formula for choosing the right dividend stocks. But sticking with stocks you know, checking valuations and payout ratios instead of yields, and reinvesting your dividends can help you get rich slowly even through the most volatile markets.