There's more to being a successful income investor than simply chasing high yields. There's more to the art of finding great dividend stocks than passively collecting the distributions. Investors have been burned by assuming that chunky yields are sustainable, or that the disbursements shield shareholders from risk.
There's a right way to be an income investor and a wrong way. Let's go over a few lessons I have learned when it comes to earning thousands -- or at least not losing thousands -- along the way.
Image source: CenturyLink.
1. Beware of sky-high payout ratios
Given the choice between buying into a stock with an unsustainably high yield or a sustainably low payout, you should do yourself a favor and go for the smaller dividend check. A quarterly distribution is only as good as the company's ability to pay it, and don't assume that a fat rate lasts forever.
Keep an eye on the payout ratio of the dividend stocks you own or are considering for purchase, especially if you're buying into a high-yielding investment. Simply divide the distributions that a company has paid over the past 12 months by trailing earnings per share. If it's a number greater than one -- a payout ratio of more than 100% -- it means the company is shelling out more than it's earning. Unless profitability is set to explode in the near term, it shouldn't be a surprise to see those disbursements cut or suspended.
Regional telcos have been a hotbed of unsustainable dividend declarations. Frontier Communications (FTR) is the latest player in this niche to nix its quarterly check. A payout ratio north of 100% isn't always fatal. CenturyLink (LUMN -0.75%) has posted a triple-digit payout ratio every year since 2011, and it has only reduced its distribution rate once in that time. However, the closer a stock is to a payout ratio of 100%, the more likely that dividend is to be reduced or eliminated if earnings growth is going the wrong way.
2. Follow the Dividend Aristocrats
A dividend increaser in motion tends to stay in motion. Wall Street calls companies that have boosted their distributions annually for at least 25 years in a row Dividend Aristocrats. A quarter of a century is a long time, indicating that the company has been able to jack up its rate despite recessions and competitive threats.
You won't typically find big payouts here initially. The average Dividend Aristocrat yields closer to 2.4%. These tend to be successful companies, and often the stocks appreciate faster than their disbursements. However, it's a great place to start. Over time, the yield based on your buy-in price gets better and better.
3. Don't ignore profit trends
An income investor's research can't stop at its yield. The best stocks are companies with strong and growing businesses that just happen to share the wealth with their stakeholders. Always asses earnings growth -- in the past and in the future.
Bringing Frontier Communications and CenturyLink back into the frame, CenturyLink has been growing its earnings in two of the past three years. Frontier, on the other hand, has seen its deficit widen in each of the past three years. CenturyLink remains a risky investment, but at least it's had its moments of recent growth. Income should always be a secondary consideration to growth, as it's the catalyst for income growth.
