Take it from me, a devoted income investor: It is way too easy to get suckered in by a big dividend yield. There's nothing wrong with high-yielding stocks per se, but you need to make sure there's more to the story than a fat payout, or you're likely to get burned.
Here are seven key lessons I've learned in my search for juicy dividends. Following them may protect you from making some painful investing blunders.
1. Use a screen
There are way too many stocks in the investable universe. So rather than rummaging through them all, you need to start with tools to help you cull out names you just won't be interested in.
My personal screen always starts with the Dividend Achievers and Dividend Aristocrats lists, which contain companies that have increased their payouts annually for at least 10 years and 25 years, respectively. However, I have a particular fondness for the Dividend Kings, which have increased their payouts each year for at least five straight decades. Some of the names I own from this last list include Procter & Gamble (NYSE:PG) and Hormel (NYSE:HRL), both of which I've owned for years, and a more recent addition to my portfolio, Federal Realty (NYSE:FRT). I added each of them during periods of price weakness when their yields were at historically high levels (see lesson No. 6, which concerns valuations).
Just because a stock is on one of these lists does not guarantee that its dividend won't get cut. However, the pattern of behavior that gets a company onto one of those lists does reflect a material commitment from management to returning value to investors via dividends. And you don't build long streaks like these without doing something right. So starting with them is a good way to quickly narrow your list of potential income investment candidates.
2. Favor large companies
Benjamin Graham, the man who helped to train Warren Buffett, created a short list of investment tactics in his classic book, The Intelligent Investor. Buying large companies was at the top of that list.
There's nothing inherently wrong with small companies, but larger ones tend to have the financial heft to compete more effectively. That spans a broad variety of topics, from business diversification to access to capital. And, let's be honest, big companies usually got that way by doing what they do very well.
Obviously, there are also large companies that aren't worth investing in anymore, but starting with bigger ones and working your way down to small ones can help investors screen out riskier picks. As an example, I own shares of W.P. Carey (NYSE:WPC) rather than Four Corners (NYSE:FCPT). Both are well-run real estate investment trusts with net lease portfolios, but W.P. Carey is about six times as large (based on market cap), is more diversified, and has a much longer history of success behind it. Four Corners might make its shareholders rich, but for me, the risks outweigh the potential rewards. I'd rather take the slow and boring approach.
3. Pay close attention to financial strength
A company's balance sheet is the foundation on which it builds its business. Ideally, you will dig into the actual numbers, looking at things like the debt-to-equity ratio, debt-to-EBITDA ratio, debt trends over time, and the current ratio. You should also take a look at the earnings statement to check on interest coverage. The idea is to develop a clear picture of how solid a company is, financially speaking. That will give you a better handle on whether or not it will be able to support its dividend when times get tough (and times always get tough, sooner or later).
Alternatively, you can simply look at the ratings provided by credit rating agencies like Moody's and S&P. This can be a good shortcut early in your research process, one that allows you to get rid of weak prospects without having to do much legwork. You want to stick to the higher-quality tiers and should probably avoid dipping below investment grade unless you have a very strong conviction in the company you are looking at.
As a quick example, at current share prices, B&G Foods (NYSE:BGS) yields a hefty 6.5% -- but it also sports a junk-bond credit rating. It wasn't a hard choice for me to pick Kellogg (NYSE:K) instead when it was recently yielding 4%, thanks partly to the packaged food giant's investment-grade credit rating.
4. The payout ratio
Next up is the payout ratio, which some might put higher up on the list. But a company with a strong balance sheet can actually pay out more than it earns for a little while without too much trouble. That's because dividends get paid out of cash flows, not earnings (which can be subject to non-cash charges that distort the metric over the short term). In general, the lower a company's payout ratio is, the better. However, you have to take into account what industry you are looking at, because some types of companies can handle higher payout ratios than others.
A good example here is utility stocks, which have large asset bases and regulated businesses with highly predictable earnings. Thus, utilities tend to carry more debt than other companies.
5. Include a sanity check
I'm not suggesting that buying dividend stocks will make you go crazy, but it is really easy to get caught up in a company's story and willfully its ignore problems. (It's a human thing, we all do it.) When I'm looking at a company, I always ask if I would want my wife to own this stock if I were dead. That sounds macabre, but my wife isn't interested in investing like I am. So if I'm not around, I'm saddling her with a portfolio full of investments that she may not fully understand. If I filled our portfolio with risky and/or obscure companies, I would be hurting her, not helping her. That's not what I want to do to my wife, so this simple question has actually kept me out of a lot of interesting investments that ended up imploding.
For example, it took me a long time to decide on a midstream investment -- despite the high yields those energy industry players offer -- because I was concerned about the complexity of the master limited partnership structure and the midstream space's long-term prospects. I ended up buying Enbridge (NYSE:ENB) because it isn't an MLP and it has made a long-term strategic decision to invest in renewables and cleaner power alternatives. It was my sanity check question that caused me to spend the extra time needed to pick a stock with which I was comfortable.
If my "filtering" question doesn't work for you, then you might go with Charlie Munger's (Buffett's partner at Berkshire Hathaway) idea of inverting: Instead of asking why the company you are looking at will do well, ask why it would fail. This could help you look past the positives and consider the negatives that might be there.
6. Don't forget growth and value
Another thing to keep in mind is inflation. Your living costs are going to march steadily higher over time, and you need to address that issue in some way. That can come from capital appreciation, dividend growth, or, ideally, a combination of the two. Historically speaking, the U.S. inflation rate has averaged around 3% a year. So finding a company with a long-term dividend growth rate that at least keeps up with that number is ideal. Note that there will be years when dividends rise more and years when they rise less, so don't get overly caught up in a single year's figures here. The goal is to find a company that has, over time, proven willing and able to reward shareholders with a growing income stream.
On the dividend growth front, I bought Hormel because it was offering a historically high dividend yield, north of 2%, and its annualized dividend growth rate has been over 15% over the past decade. That more than makes up for the low starting yield and provides protection against inflation for my entire portfolio.
Capital appreciation is a bit more difficult to predict since investor sentiment plays such an important role. However, avoiding companies that look historically expensive is one way to reduce your odds of overpaying for a stock. You can actually use the dividend yield to help here, by focusing on stocks with historically high yields. Price to sales, price to earnings, price to book value, and price to cash flow are also ratios that can help you figure out if you are paying too dear a price for a stock (which could limit your capital-appreciation potential) or are getting a bargain. Bargains are better.
7. Spread your bets
This last point is more of a portfolio-level issue, but it impacts individual stock selection, too. Diversify your portfolio across companies and industries so that no single mistake can do too much damage. It would be nice if every investment we bought went up, but that's just not how the world works. You want to limit the impact of your poor choices, and diversification is the easiest way to do that.
And, by putting your eggs in multiple baskets, you increase the likelihood that even when some of your stocks aren't doing well, others will be thriving. That will smooth out your returns over time -- and also give you something positive to look at when markets are turbulent. (And in turbulent times, it can be a good strategy to focus on the dividends you are collecting so you can avoid considering the overall value of your portfolio.)
Time to dive in
I wish I could tell you that if you follow these rules you'll make perfect investments, but that's just not the truth. However, they should help you avoid making catastrophic mistakes from which you can't recover. And, over time, the combination of avoiding big mistakes and enjoy the compound growth of your winners could help turn you into a very wealthy investor.