In this week's episode of Industry Focus: Energy, Nick Sciple talks with Fool.com's Matt DiLallo about energy dividend plays. Matt shares three of his favorite dividend payers in the energy and industrials industry, and what he personally looks for in a company before he adds it to his portfolio.

Learn what metrics to watch out for, and how those metrics change depending on industry; how these three companies stack up on those metrics; how to look at dividend payers outside of the energy industry; how to invest in dividend plays with an eye toward a potential recession; and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 23, 2020.

Nick Sciple: It's Thursday, January 23rd, and we're discussing dividend stocks. My guest today is Motley Fool contributor Matt DiLallo. Matt, great to have you on!

Matt DiLallo: Hey, thanks for having me!

Sciple: All right, Matt, I'm excited to be talking about dividend stocks today. I know your personal portfolio has a pretty heavy weighting in dividend stocks. What makes dividend stocks so attractive to you as an investor?

DiLallo: It's hard to not like getting paid for work you didn't do. I think that was the initial thing that drew me to dividend stocks years and years ago. But I've learned as an investor and working for The Motley Fool, been able to read a lot of research on dividends. And they actually tend to outperform regular stocks by a pretty wide margin. There's a really great study out there that listeners can google, from Ned Davis Research. They found, I think it dated back from 1972, that dividend payers outperformed the S&P 500. A company that paid a dividend was 8.8% per year annualized return versus the S&P at 7.3%. Now, what was really interesting was, companies that grew their dividend, they were the big outperformers at 9.6%. Companies that didn't increase their dividend, they underperformed, as did companies like cut their dividend and the non-payers. Non-payers are your traditional growth stocks. There's so much volatility, so they were a lot less. Data like that, and then just seeing the compounding in my portfolio, has really helped me to encourage me to keep buying dividend stocks, focusing on that.

Sciple: Yeah, especially when you look at returns over the long term. If you don't factor in that dividend, you can really not get a true picture of what that return will look like. But if you reinvest dividends over the long term, you can really augment your returns. And to your point, Matt, those companies that have paid dividends and increased them over time tend to be those companies we like to invest in. When you look at a potential dividend investment, what are you looking for in these companies?

DiLallo: I tend to be very conservative with what I look for because I've gotten burned on dividend stocks. I think a lot of beginning investors, you see that yield, and it's 7%, 8%, 9%, and you chase that yield. And there's usually a reason. Unless it's something like an MLP or a REIT, which are two special tax-advantaged vehicles, when dividends get that high, it's kind of a question. So, I look for something that has a very conservative balance sheet. I look for investment-grade balance sheets, which is when credit rating agencies tell investors, "Hey, this is a good, strong balance sheet." I look for the metrics based on the sectors. Energy sector has its own set of metrics, just like the auto industry and things like that. But, I'm looking for someone that has a strong balance sheet, because that'll give them the financial flexibility during tough times like recessions.

I'm also looking for predictable and stable cash flow, because that's what they pay dividends out of, is their cash flow. So, I'm looking for, it's got to be profitable, it's got to generate more cash than it needs to run the business. So, I'm looking for that. And then, with what they have cash flow-wise, I'm looking for a conservative payout ratio. That really varies by industry. Ned Davis found that 41% is actually a really good rate, but up to 71%, if it's an MLP or REIT, those are fine.

And then, I'm looking for growth, because dividend growers are the ones that outperform. I want to see visible growth, whether it's in a market that's expanding, or you can see it around the horizon.

Sciple: Exactly, Matt. So, within that framework of dividend stocks, we asked you to bring your top three that you're most excited about today. Let's run through those. The first one you have for us is Enterprise Products Partners (NYSE:EPD). What can you tell us about that company?

DiLallo: Enterprise Products Partners, that's an MLP, which is a tax-advantaged entity. It's focused on energy midstream. So this is your pipelines, your storage. Again, that's going to be a stable business. It doesn't have as much exposure to commodity prices. Even though oil and gas do impact these companies, their cash flows tend to be very strong. In Enterprise's case, it's grown its cash flows for almost the past two decades. And that's enabled it to pay a really good yield at 6.1% at the moment, and grow it. So, just hitting on the characteristics. I talked about balance sheet. It's got the best balance sheet in the MLP sector. Its credit is top of the line. It's got a low leverage ratio. So, it hits that mark.

And then, I talked about stable cash flows, predictable cash flows. 80% of Enterprise's come from fee-based contracts or similar structures. So, that's very predictable, especially in the energy industry. And then, I mentioned I'm looking for a conservative payout ratio. They were 63% last year. That's very conservative for the sector. Most MLPs have been 80% or plus, and that's why they've struggled over the past couple years. And then, the last thing is that growth. In this case, Enterprise has $9.1 billion of expansion projects under construction. That's going to keep them growing through 2023. So, that visible growth, you can see ahead, they're going to continue to grow the cash flow. And they can fund this because of that conservative balance sheet and the low payout ratio. So, they've got the internal funds to continue growing not only their business, but their distribution.

Sciple: Right. I mean, just a few years away from being a dividend aristocrat. When you look at the sector, you mentioned it's really struggled. You look over the past three years, you look at the ETF for the sector, down 33% or so. But Enterprise Products Partners has been stable over this time because of that strong balance sheet. So, definitely a company to pay attention to.

You second company on the list is one we've talked about a fair amount on this show, Brookfield Infrastructure Partners (NYSE:BIP). For folks who have maybe not heard us talk about that company in the past, can you introduce them to what this company does?

DiLallo: Brookfield is a little bit similar to Enterprise in that it's a publicly traded partnership. It's not quite an MLP. It's a little bit different. It gives that schedule K-1 that a lot of investors are kind of not familiar with. However, they're going to spin off a corporation coming up later this year. That will give investors that 1099 form that they're familiar with. But this company, it owns those midstream energy assets that a lot of energy investors are familiar with. However, it also has utilities, transportation, and data infrastructure. The transportation and data infrastructure is interesting, and it's got a lot more growth from there. That's why I kind of like that one.

Sciple: Yeah. Can you talk about the growth opportunity there in these new areas they're moving into? I think data is a new opportunity for them. Why have they pursued these new arenas?

DiLallo: Yeah, data is huge. As many of the listeners probably know, mobile data, we're just using our cellphones to do more and more things. And with 5G coming, there just needs to be more ability to transport data. And so, Brookfield, they're buying data centers which store the data, they're buying these fiber optic cables, which help kind of move data quickly, and then cell towers in places like India and France. And so, it's all about facilitating and being able to store data so that we can just continue to grow as a society. That's just really exciting. It's an interesting way of playing the data growth. And then they have transportation, which is unique, too. They're buying -- I think we talked about on the show a while back -- Genesee & Wyoming railroad. So, they've got that in there. It's unique assets that are very stable, pay a lot of cash.

Sciple: Yeah. We think about, Brookfield Infrastructure Partners, and when we think about infrastructure, we often think about roads and bridges and that sort of thing. But when we think about the internet, there is an infrastructure that needs to operate on the back end of that, whether it's cell towers or data centers or that sort of thing. And there is money to be made in that business. When you look at the Brookfield Infrastructure Partners dividend and how it stands up against your checklist you laid out at the beginning of the show, how does it stand up?

DiLallo: Yeah, so, Brookfield Infrastructure Partners, they've got that top line balance sheet, I'm looking at investment-grade, low corporate leverage. And a lot of times when they buy their businesses, because they have a lot of private equity focus, and a lot of times, private equity companies put a lot of debt on these; Brookfield doesn't do that. Anytime they buy a business, it's always done to investment-grade credit ratings. That just gives them that stability of their balance sheet.

And then, as we mentioned, they operate these businesses that generate stable cash flows. 95% is regulated or fee-based. We mentioned data, the data centers, it's kind of like they'll rent those to companies that just need a place to store their data. Same with cell towers, they rent it out to mobile communications. So, they're just getting paid these consistent cash flows through that. They also have a conservative payout ratio. They target 60% to 70%. That gives them 30% to 40% of their cash flow to reinvest in acquisitions and expansion projects. And then, that gives them the opportunity to grow. In Brookfield's case, they're targeting 6%-9% per year organic growth. And then, acquisitions. We mentioned the railroad that they're buying, Indian cell towers. You've got a lot of growth there. In fact, they're looking at growing their earnings 25% this year from where they were back in 2018. So, a lot of growth there. I like that visible growth, because that means the dividend's going to grow.

Sciple: Yeah, I mean, you talk about growth, you talk about the dividend. From a capital appreciation standpoint, this stock has been a monster over the past several years. Up 50% or so. That's pushed the yield down about 3.7%. But when you're getting all that capital appreciation on the back end, that's really a great stock to have.

Last one on the list, another one that we've spent a fair amount of time talking about on the show, NextEra Energy (NYSE:NEE). Again, just high level, what does this company do?

DiLallo: NextEra Energy's a utility, they own two utilities in Florida, and then they have a renewable energy business where they'll build wind farms and solar plants and then they'll sell the power under long-term contracts to other utilities and end users. Both of those businesses tend to generate very predictable, steady cash flow. I really like them particularly for that renewables business. There's just so much growth ahead in renewables, and they're one of the tops in the business at doing that.

Sciple: Yeah. We talked on the show in the past, they have this Florida utility in addition to these power purchase agreement businesses, they'll go out and contract with other businesses to provide renewable energy to other utilities. Again, looking at the dividend, how does it stand up against your checklist?

DiLallo: Yeah, very, very good business. High credit ratings, one of the best in the utility sector. Nearly 100% of their cash flows are regular or fee-based, so very predictable cash flows. They have a low payout ratio of 60%, versus most utilities at 70%, so that gives them a little extra cushion to invest in growth. And because of that, they see their earnings per share growing at 6%-8% through 2022. And a lot of that's backed by their renewables. They have the biggest backlog in their history. So, there's just a lot of growth coming. They have the balance sheet to fund that growth, which gives them the ability to grow their dividend.

Sciple: Yeah. And this is another one, if you look over the past year from a capital appreciation point of view, the stock up over the past year 47%. What opportunities do you see there, in addition to the dividend, for just the stock to appreciate over time?

DiLallo: Yeah, what's interesting about NextEra is, when a lot of investors think about utilities, they think about slow growth, just getting the dividends like a bond. Not so with NextEra. They've outperformed the market for years and years and years. And a lot of it's because they are able to invest for high returns. They focus on projects that generate good returns. And we don't think about renewables being high-return investments, but they're able to leverage the scale of their business and tax credits and things like that to actually get good returns on these projects. So, with having the largest renewables background in the history, and then just the focus in the past couple years with climate change, there's just so much opportunity for them to expand that it's a really exciting company to own for what typically is just a no-growth kind of industry.

Sciple: Yeah, absolutely. When you think about renewables, massive tailwind, and NextEra has been at the forefront of that industry for a long time. So, great opportunity there to invest both for a dividend-paying company, but also, the stock has performed quite well over time.

Matt, those are energy dividend payers that are your favorite. When you look outside of the energy industry, does your criteria change when you look at a dividend company? Are you looking for anything different?

DiLallo: It doesn't change, but what will change is the metrics. I'm always looking personally for investment-grade balance sheets, it possible, or something that has low leverage metrics for the sector. That's going to vary. Energy stocks, because they have such predictable cash flow, they're able to carry more debt than, say, an automaker or tech stocks. So, in those cases, I'm just looking for what's consistent with that sector. Sometimes it might not be the investment-grade balance sheet, but a lot of tech stocks, for example, have just a ton of cash on their balance sheet. So, that's a good cushion for the dividend. What I'm looking for is, I want a company to pay the dividend when things get tough, because it's going to get tough. We've had 10 good years for the global economy, but at some point, a recession is going to come, and I want that dividend to last. So, I'm also looking for something that has stable cash flows when the recession hits. That's going to vary by industry. But, for example, like a Comcast or a Verizon, they have a lot of consumers that are going to pay their cellphone bill, they're going to pay the cable bill. And so, you're getting that predictable cash flow. Same with a Johnson & Johnson that sells Band Aids and consumer products. You're looking for that stability if you're focusing on dividends. And, again, the low payout ratio. That's going to vary by industry. For something that's not a REIT, which is a real estate investment trust, or MLP, 40% or less is kind of the target for that. So, again, it's going to change a little bit. You're just looking for conservative because it's all about sustainability.

Sciple: Exactly. I look at the dividend payers in my portfolio, I think MasterCard is the one that jumps out based on those criteria that you listed out, massive tailwinds when it comes to moving payments digital. You have this infrastructure that the credit card companies MasterCard and Visa have built up over time that are just really difficult to disintermediate. And however the economy performs, we may spend less in a down economy, but we're always going to be continually paying. I don't know about you, Matt, but for me, personally, I spend everything on my credit card and just pay it off every month. How do you use your credit card?

DiLallo: The same way. That's why MasterCard and Visa are two of my biggest holdings, because I know every time I swipe, that's going to be cash that's going into their balance sheets, and they're going to use it to buy back stock and dividends. Yeah, that's a really good one.

Sciple: Absolutely, Matt. Well, thanks as always for coming on the show to share your favorite dividend stocks. Listeners, I hope you got a few for your watch lists, maybe a couple to add to your portfolio. Looking forward to having you on again soon, Matt.

DiLallo: Hey, thanks for having again!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Matt DiLallo, I'm Nick Sciple, thanks for listening and Fool on!