If you're looking for that elusive combination of healthy current investment income and the potential for future growth, dividend stocks are the right place to start. But with so many different stocks to choose from, how can you find the best dividend payers out there -- without risking a big dent in your portfolio?
Not for the meek anymore
Traditionally, dividend stocks have been considered less risky than the average stock. Companies would usually not pay a dividend during their initial high-growth phase; only after they had matured and their businesses had started generating substantial excess cash flow would they stop plowing every spare cent into their own internal growth, and instead begin making payouts to shareholders. Once a company had settled down, investors could often rely on companies' maintaining their dividends for decades.
Recent events, though, have turned that wisdom on its head. Former dividend stalwarts like Dow Chemical and General Electric had to cut their dividends earlier this year, breaking long histories of sustained dividend growth. At the same time, even well-established companies like Cisco Systems
Playing it safe
Today, dividend stock investors have to be careful with the stocks they pick. It's not enough just to look for the highest-yielding stocks you can find; too often, some piece of bad news will force them to reduce their payouts. That often causes a mass exodus among investors, further depressing share prices.
In doing your research, you should search for a combination of factors that make dividend stocks particularly attractive:
- A healthy dividend yield that's high enough to provide good income, but not too high to sustain.
- A solid payout ratio, meaning that the company's earnings and/or cash flow far exceed what it's paying out in dividends.
- A history of raising dividends gradually but consistently over time, which can help you battle the impact of inflation on your dividend income.
But if you don't have the time or inclination to search out your own individual stocks, there's a shortcut that can give you good ideas: looking at successful mutual funds that focus on generating dividend income.
Filch from top funds
Equity-income funds are tailor-made for dividend seekers. With the objective to produce current income from stock portfolios, you'll find lots of strong candidates among the top funds' holdings.
For instance, Parnassus Equity Income (PRBLX) has generated a 6.5% average annual return over the past 10 years, putting it in the top 1% of its peer group. Not all of its stocks pay dividends, but two of its top holdings, Microsoft
Similarly, Amana Trust Income (AMANX) owns a familiar group of solid stocks like Procter & Gamble
For those seeking some smaller stocks, the Nicholas Equity Income (NSEIX) fund may be worth a look. Its 5.6% average return over the past five years doesn't hold up quite as well as some similar funds, and its 10-year performance is well below par. But holdings such as Microchip Technology and RPM International
Go your own way
Of course, rather than milking these top funds for ideas, you could simply invest in them yourself. That's not an unreasonable course, if you have absolutely no desire to pick your own stocks.
But top funds can teach you quite a bit about investing, if you're open to learning. By watching how top dividend-fund managers seek out their investments, you can build your own investing strategy, and become increasingly comfortable choosing the best dividend stocks all on your own.
