The novel coronavirus (COVID-19) pandemic has gutted many dividend stocks over the past month, as investors worried that the abrupt disruptions of cash flows would force companies to cut or suspend their dividends.
Yet many babies were tossed out with the bathwater, and the following five simple steps will help investors spot bargains that could generate thousands of dollars in annual dividends.
1. Spot the accidental high yielders
There are generally two kinds of high-yielding dividend stocks: those that decline for specific reasons, including a cyclical downturn or disruptions to their business, and those that merely tank with the broader market.
AT&T (T 1.27%), which pays a hefty forward yield of over 7%, lost nearly 20% of its value over the past month due to concerns about delayed movies hurting its WarnerMedia business, its loss of pay-TV subscribers, and potential delays for its 5G plans. It also suspended a big buyback plan that would have boosted its earnings throughout the difficult period. Therefore, we can't really consider AT&T an "accidental" high yielder yet.
Coca-Cola's (KO 0.76%) stock also slid about 20% over the past month as its forward yield nearly hit 4%. Yet Coca-Cola doesn't face specific near-term challenges like AT&T; demand for its beverages should remain stable throughout the crisis, and it still has plenty of irons in the fire. In other words, Coca-Cola's yield was "accidentally" boosted during the sell-off -- which arguably makes it a more compelling buy than AT&T.
2. Payout ratios matter more than yield
Investors should also pay attention to a stock's payout ratio, or the percentage of its earnings per share (EPS) or free cash flow (FCF) the company spends on dividends, instead of its yield. If either ratio exceeds 100% for too long, the dividend could be cut.
That's precisely what happened to Macy's (M 2.20%), which recently suspended its dividend after it hit a whopping yield of 24%. Macy's spent over 100% of its FCF on its dividend over the past 12 months as it struggled to grow its comparable-store sales and margins, so it clearly needed to suspend the dividend to weather the coronavirus crisis.
AT&T and Coca-Cola spent just 51% and 81% of their FCF, respectively, on their dividends over the past 12 months. Both companies are also Dividend Aristocrats, or members of the S&P 500 that have raised their dividends for at least 25 straight years, and they'll likely maintain that elite title for the foreseeable future.
3. Free cash flow growth matters
If a company is spending too much money or is shouldering too much debt, its FCF levels will decline and cripple its ability to pay dividends or buy back shares. If we compare the FCF growth of AT&T, Coca-Cola, and Macy's over the past decade, we'll see why Macy's suspended its dividend:
Companies that regularly spend most of their FCF on buybacks and dividends will also likely suspend the former before the latter. That's why AT&T recently halted its buybacks, which consumed 7% of its FCF over the past 12 months.
4. Mind the sector
The recent market sell-off has been particularly brutal for certain sectors of the economy. Energy stocks were crushed by the oil price war between Russia and Saudi Arabia, banking stocks were wrecked by zero interest rates, and retail stocks were hit by lockdowns and quarantines aimed at taming coronavirus infection rates.
Plenty of high-yielding stocks are littered across those battered sectors, but many of them are high-yield traps instead of bargains. In this volatile market, it's safer to stick with dividend stocks in better-insulated sectors like technology, consumer staples, and utilities.
5. Always reinvest your dividends
Lastly, always enroll your stocks in dividend reinvestment plans (DRIP), which automatically use dividends to buy additional shares of a stock. DRIPs help you accumulate more shares at lower prices and fewer shares at higher prices -- which gradually boosts your total dividend payments.
That difference might seem minor over the course of a few quarters, but the magic of compounding results in a significant difference between a stock's price appreciation and its "total return" with dividends reinvested. For example, Coca-Cola's stock rose about 88% over the past 20 years. If you collected all your dividends as income, it would equal a total return of 177%. If you had reinvested those dividends, you'd be sitting on a total return of 236% instead.
The bottom line
Dividend stocks might seem dull, but they often generate stronger and more stable returns than volatile growth stocks over the long term. However, investors should do their homework, avoid chasing high-yield traps in battered sectors, always reinvest their dividends, and maintain a long-term view of the market.