With interest rates at rock-bottom levels, it can be hard to find high-yielding investments for your portfolio. Buying 10-year U.S. treasuries currently only pays you a tad over 1% a year, while buying a broad-based S&P 500 index fund has a meager dividend yield of 1.3%. Both these payouts are at or near all-time lows.
So what's an investor looking to increase their portfolio's yield to do? One way is to buy individual stocks with above-market dividend yields. Here are three tips for anyone buying dividend stocks to help improve your chances of success.
1. Understand payout ratio
A vital part of any high-yield dividend investment strategy is evaluating whether the company's current and future dividend payments are sustainable. The easiest way to do this is by calculating the stock's dividend payout ratio. A payout ratio is the percentage of earnings a company is paying out each year to shareholders in dividends and can be calculated with a simple formula:
Total Annual Dividend Payments / Annual Earnings = Dividend Payout Ratio
If a stock's dividend payout ratio is above 100%, that means the company is currently paying out more in dividends than it is earning each year, which is not sustainable unless you believe earnings can grow from historical levels. If a dividend payout ratio is well below 100%, that indicates a company has the ability to pay a much higher dividend to shareholders if it wanted to.
A negative example of this is Boeing (BA 1.25%). In 2019, the company paid a dividend of $8.19 per share. In early 2020, when the stock plummeted below $150 with COVID-19 fears and the continued repercussions of the 737-MAX scandal, Boeing's trailing dividend yield looked high at the time. But the company was losing money each quarter (and has lost money every quarter since), which caused management to cut its dividend to zero, leaving income investors out to dry.
2. Go for growth
If you are having trouble finding investments with high current dividend yields, it may be smart to look for stocks that have a history of increasing their dividend payouts or with plans to increase their future dividend payouts.
Companies in the S&P 500 that have increased their annual dividend every year for at least 25 years are called Dividend Aristocrats. They are a great hunting ground for stocks that have the potential to steadily grow their dividend payouts in the future.
For example, Coca-Cola (KO 1.57%) only paid investors a dividend of $0.01 per share (adjusted for stock splits) back in the early '80s, but after a few decades of steady growth, it now pays investors $1.64 per share a year in dividends, a 3.82% yield based on the current share price. Finding stocks with strong track records of dividend growth like Coca-Cola is a great way to optimize your dividend investing strategy.
3. Avoid certain industries
Not all dividends are created equal. Sometimes stocks have high current dividend yields that are unsustainable or at risk of going away because of the industry the business operates in. Two places individual investors should stay away from are cyclicals and commodities.
Cyclicals: A cyclical is a business that is affected by the business cycle (it does well in good economic times, but bad when the economy is in the hole). Since the business cycle is extremely difficult to predict, buying a stock in an industry with a history of cyclicality is riskier than buying one that is not. An example of a non-cyclical company is our friend from above, Coca-Cola. No matter the economic environment, people seem to like sugary drinks, which makes Coke's business a lot more predictable than one selling more discretionary products like new cars or luxury goods.
Commodities: Commodity companies are those whose businesses follow commodity prices. For example, a company like Barrick Gold (GOLD 3.25%), which mines and sells gold, could see its profits tumble if the price of gold goes down. This makes commodity-driven businesses highly unpredictable, which means as investors you can't take any current dividend payouts at face value.
Dividend investing, like all forms of investing, requires patience and discipline. But if you understand what a payout ratio is, focus on growth, and avoid cyclicals and commodity stocks, you'll be well on your way to building a resilient dividend stock portfolio.