Dividend stocks generally aren't as exciting as high-growth stocks (nor as volatile), since companies usually only start paying out dividends when they begin running out of room to grow. Nonetheless, most investors striving to own a diversified portfolio of companies should consider adding a few dependable dividend stocks that can generate stable long-term returns during market downturns.
To help in spotting the top income stocks out there, investors should remember these four simple tips.
1. Never chase the highest yield
Many investors focus on a stock's dividend yield (its annual dividend as a percentage of its stock price) when they choose income-generating stocks. However, chasing the highest-yielding stocks can be a dangerous strategy.
A stock's yield might have skyrocketed because its stock price dropped. If a company's stock price dropped due to temporary headwinds, this could just be an "accidental" high-yielder that's worth buying. But if the price declined due to long-term challenges or secular headwinds, it could continue dropping, and wipe out whatever gains your dividends are producing every year.
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For example, AT&T (T 0.63%) might seem attractive at the moment with its generous forward dividend yield of 7%. But over the past three years, its stock price has tumbled nearly 20% as the growth of its wireless business decelerated and it lost pay-TV subscribers to streaming platforms.
Altria (MO 1.75%), the domestic tobacco giant that owns Marlboro, might also look tempting with its forward yield of 8.3%. However, its stock price has fallen more than 40% over the past three years as it's struggled with declining smoking rates and bad investments.
During those three years, shares of Coca-Cola (KO 0.78%), which pays a lower forward yield of 3.1%, rose 15% and easily outperformed AT&T and Altria. The same can be said about Johnson & Johnson (JNJ 0.63%), which rose 6% while paying a lower forward yield of 2.7%.
2. Check the cash dividend payout ratio
The easiest way to see if a dividend is sustainable is to check a company's payout ratio, or the percentage of its earnings per share (EPS) it spent on dividend payments over the past 12 months. If that percentage exceeds 100%, its dividend could be reduced -- or suspended.
However, payout ratios can be misleading, since a company's EPS can be distorted by stock buybacks, acquisitions, divestments, and other variables. To get a clearer picture of a dividend's sustainability, investors should examine its cash dividend payout ratio -- the percentage of a company's free cash flow (FCF) paid out as dividends over the past year -- and its long-term FCF growth.
AT&T's payout ratio of 135% initially looks unsustainable. However, its more sustainable cash dividend payout ratio of 53% suggests it won't break its 36-year streak of annual dividend hikes anytime soon.
3. Annual dividend hikes matter
Companies that consistently raise their dividends are often considered stable investments, since it indicates they're generating stable profits and cash flows over long periods.
Members of the S&P 500 that have raised their dividends annually for at least 25 straight years are dubbed Dividend Aristocrats, while those that cross the half-century mark of consistent payout hikes are crowned Dividend Kings. Those elite lists are great starting points for investors looking for reliable long-term income investments.
4. Always reinvest your dividends
Most brokerages let investors enroll their dividend-paying stocks in dividend reinvestment plans (DRIP). DRIPs automatically use a company's dividends to buy more shares of the stock at a discount to the market price.
Reinvesting dividends generates compound returns, since your annual dividend payments will increase as you accumulate more shares. If we compare Coca-Cola's stock price with its total return, which factors in reinvested dividends, we'll see a jaw-dropping difference over the past 10 years:
Source: YCharts
The key takeaways
Dividend stocks are generally good defensive investments, but only if you weed out damaged businesses, high-yield traps, and companies with weak cash flows. Like a fine wine, good dividend stocks also become much more valuable as they age -- especially if you reinvested the dividends instead of accepting the cash payments.
