For those of us preparing for retirement, or already there, identifying a steady source of income that keeps up with inflation is an important consideration.
Owning dividend-paying stocks is a good way to complement Social Security, pensions, and withdrawals from your 401(k), IRA, or other retirement account. In addition to the quarterly payouts, there is the chance that the share price will rise.
How do you pick stocks that will pay -- and, optimally, increase -- dividends over the long term?
Aristocratic behavior
One way is to identify a blue-chip stock off the list of companies that have paid and increased dividends over a long time. In the case of the 54 businesses that are members of the S&P 500 Dividend Aristocrats, that period is at least a quarter-century. The full list can be found here.
The idea is that if these companies have been doing it for 25 years or more, they have a strong track record of dividend increases. This approach may work for some investors, but there is no guarantee that the company will be able to keep increasing the dividend -- or even paying it at all. Some companies have dropped off the list when something "unexpected" occurred.
One company on the list is pharmaceutical giant Johnson & Johnson (JNJ +0.51%), which has been increasing its dividend every year for more than a half-century. Over the last five years, both the share price and the dividend have appreciated by more than 40% -- a compounded annual rate of nearly 7%.
Johnson & Johnson has been able to bump up its payouts because of a steady stream of cash flow derived from its lineup of ready-for-market, patent-protected drugs like Invokana and Simponi, innovations and acquisitions in its surgical-device business, and over-the-counter health-care products such as Tylenol and Band-Aids. Johnson & Johnson has also been able to keep a lid on debt. Its long-term debt-to-equity ratio is 0.14, and it won't need to use much cash to service the load.
Screening for dollars
Besides just looking at a list, it takes a deeper dive into the details to determine whether dividend payments will continue and grow and whether the original capital investment is well-spent. Looking at a few key characteristics will help narrow down the search for income-producing stocks.
Looking at earnings and cash-flow growth over the long term -- three to five years minimum -- is an important part of the selection process. In addition, if a company has too much debt on its balance sheet, it is possible that future earnings will be diverted there, rather than a dividend. A relatively high payout rate might prevent a company from increasing the dividend unless it borrows to fund it.
Here are two stocks that meet those criteria.
Priceless
Credit card processing company MasterCard International (MA 3.30%) scored high in all of the screening criteria, including strong average EPS and cash-flow growth (more than 20%) over both a three-year and five-year period, a low current payout ratio of 8%, and no debt to speak of. MasterCard rode though the 2008 financial crisis without any major problems.
MasterCard is expected to continue this growth trend into the future by expanding in international markets. The U.S. market will have less influence on the company's performance, while Asian and Latin American countries will have more going forward. China and India will be particularly important for MasterCard, with their up-and-coming population and so-far-untapped market looking to use the company's services down the road.
Tech giant pays out
Tech giant Apple (AAPL 1.45%) also looks good in the dividend-paying arena. Although slowing somewhat recently, the company has had impressive growth (more than 60% on average) in EPS and cash flow over the last three and five years. It sports a low dividend-payout ratio (41%) and has a debt load of less than 11% of capital.
Apple has been able to achieve these numbers by selling lots of high-margin devices that consumers love, such as the iPhone, iPad, iPod, and iMac, and has been able to do it in an effective and efficient way.
The cash rolling in has allowed Apple to pay a considerable dividend of $3 per share and buy back some of its own stock. Both actions help return value to investors.
Based upon continuous improvements and innovations in its product lineup, and a typical yearly refresh cycle that keeps users looking forward to the next new product, it is likely that Apple will be able to grow and keep paying the dividend into the foreseeable future. However, do bare in mind companies sometimes stop paying a dividend --- Apple previously paid a dividend and stopped in the mid-1990s before reinstating it in 2012. Based upon the factors outlined above Apple probably won't do that again.
Over the past month, Apple has announced updates to all of its major products. New iPhone and iPad models incorporating the latest technology should continue to be big sellers.
Conclusion
For retirees seeking a steady and growing income stream to complement other sources of cash, it is important to consider dividend-paying companies that possess certain key traits.
It appears that MasterCard and Apple have those characteristics, which include strong earnings and cash-flow growth over a relatively long time horizon, low debt levels, modest payout rates, and the expectation that the growth will continue in the future based upon product improvements and updates, as well as expansion into new markets.
Johnson & Johnson has been able to pay and increase dividend payouts for a half-century. Based upon wide moats in patent-protected drugs and innovations and acquisitions, it is probable that it will be able to keep up the pace.
