A dividend yield of 2% or 3% may not sound like much, but dividends are the foundations upon which a majority of great retirement portfolios are built.
Dividend payments provide three major benefits to shareholders. The first one is obvious: They put more money in your pocket. If you're up on your position, that means icing on the cake; if not, then a dividend is a hedge against your current unrealized losses.
Secondly, dividend payments act as a beacon for Wall Street and investors, alerting them to the sustainability and profitability of a company's business model. If a business has consistently paid a dividend to its shareholders and raised that dividend on a somewhat regular basis, then it's signaling to investors that it has confidence in its long-term business model. In essence, why would a business share its profits with investors if it feared for its intermediate or even long-term profitability?
Lastly, what makes dividends such a transformative investing tool is that they can be reinvested back into the same stock. Using your payout to purchase additional shares of stock can supercharge your portfolio and, depending on your time frame to retirement, multiply your nest egg.
That said, not all dividend stocks are created equal. In fact, based on data from Finviz, more than half of the 7,100 publicly listed stocks paid a dividend (either a regular dividend or a special one-time dividend) over the trailing 12-month period.
What makes a dividend "best of breed"?
Income investors should generally search for "best of breed" dividend stocks. As the name implies, these are the top dividend plays you can buy and hold over the long term.
The way I view it, the best-of-breed dividend stocks can be broken down into three categories: high yield, sustainability, and growth. Let's look at an example or two in each category so you'll have a good idea of what a best-of-breed dividend stock looks like.
High-yield best-of-breed dividend stocks
The first type of dividend stock income investors typically seek out is the "home-run hitter," also known as the high-yield dividend.
High-yield dividends -- or, arbitrarily, any stock with an annual yield above 4% (the average yield among companies in the S&P 500 is 2%) -- have an immediate impact on any portfolio, and they're especially sought-after by retirees and pre-retirees sitting on a mound of cash. However, they can also be extremely risky if their dividends aren't sustainable over the long term. Among best-of-breed high-yield dividend stocks, I personally prefer Philip Morris International (PM -1.19%) and Alliance Resource Partners (ARLP -1.56%).
Philip Morris International produces tobacco products outside the United States, and it has excellent geographic diversity for its products. More importantly, it can avoid falling victim to tightening tobacco laws in any single country, which is what's plaguing many U.S.-based tobacco producers.
Philip Morris has particularly strong potential to grow in emerging markets such as China and India, where there are new entrants into the middle class each year looking for simple luxuries, including cigarettes. Given Philip Morris' excellent pricing power and world-leading premium brand (Marlboro), I'd call its nearly 5% yield a safe bet.
Alliance Resource Partners, on the other hand, is a coal mining limited partnership, which is probably the last industry you'd expect me to recommend. But Alliance Resource Partners does one thing very well that few other coal miners do: lock in contracts well in advance. Based on its latest quarterly results, Alliance Resource Partners has 96% of its production locked into contract in 2015 -- and, based on its estimated 2015 production, about 71% for 2016, 31% for 2017, and 24% for 2018. This leads to predictable and guaranteed cash flow, as well as minimal exposure to wholesale coal prices.
Even more impressively, Alliance Resource Partners is riding a 28-quarter streak of increasing its dividend. As a limited partnership, it receives some level of tax benefits, and those benefits are passed along to shareholders in what is currently a 7.7% yield.
Best-of-breed sustainable dividend stocks
The second category of income stocks that you need to know are the sustainable dividend stocks. These may not have flashy 7.7% yields, but they'll deliver just about the safest dividend you can possibly find. Here I'm thinking about names such as Coca-Cola (KO -0.12%) and Procter & Gamble (PG -0.39%).
Both Coca-Cola and Procter & Gamble are Dividend Aristocrats, or dividend stocks that have increased their annual payouts to shareholders for a minimum of 25 straight years. Currently, there are more than four dozen stocks that qualify, but just a handful have a streak extending beyond 50 years. In February Coca-Cola raised its dividend for the 53rd straight year, while P&G marked its 59th consecutive annual increase in April. Both also had nearly identical yields of 3.2% to 3.3% at the time of this writing.
What makes Coca-Cola's and P&G's business models so safe is that their products border on being basic necessities. Shareholders in these stocks are fully aware that growth tends to be minimal (low to mid-single-digits at best), but they're also betting that Coca-Cola and P&G can survive a recession in far better shape than most stocks. Coca-Cola sports 20 beverage brands worth at least $1 billion apiece, while P&G has 22 brands above the billion-dollar mark, up from just 10 in 2000.
Exceptional pricing power and product diversity should give shareholders in both companies the confidence to hold them over the long term.
Best-of-breed growth dividend stocks
The last best-of-breed category to consider is rapidly growing dividend stocks. These companies may lack the punch of a high-yield or sustainable dividend, but they have the growth potential to quickly become income stocks to be reckoned with. Here I'm thinking about a biotech blue-chip stock like Amgen (AMGN 0.03%).
Amgen only began paying a regular quarterly dividend in 2011. However, in less than three years its quarterly payout has nearly tripled from $0.28 to $0.79, including a 30% year-over-year increase in 2015.
What's driving Amgen's growth? For years its sales were relatively stagnant, so it relied on share repurchases to push EPS figures higher. Now, however, it has 10 compounds heading through late-stage clinical trials between 2014 and 2016, and these have already resulted in a few approvals from the Food and Drug Administration (Corlanor for heart failure and Blincyto for a rare form of acute lymphoblastic leukemia). These high-margin new drugs, combined with Amgen's cost cuts -- which include laying off 20% of its global workforce in 2014 -- should mean beefy operating margins and a growing dividend for years to come.
What's your best-of-breed dividend stock?
To be perfectly clear, there are far more best-of-breed stocks than the five I've listed, although any additional best-of-breed dividend stocks will more than likely fall into one of the three focus categories noted above. Dividend stocks that meet one or more of these criteria, and that have a business model that can stand the test of time, are your best bet to laying the foundation for a comfortable retirement.
This begs the question: What's your personal best-of-breed dividend stock?