Image source: Getty Images.
Dividend investing isn't sexy. It takes a commitment to the slow and steady process of buying well-known companies and letting those quarterly payments compound year by year. But even devoted income investors can leave thousands of dollars on the table when they forget about the three strategies listed below.
If you think you have what it takes to get rich the right way -- and by that, I mean the "Get rich slowly" approach -- then don't ignore these tips.
1. Aim for Dividend Aristocrats with payout ratios under 75%
There are thousands of dividend-paying stocks out there for you to buy. One easy way to winnow down the list is to focus on Dividend Aristocrats. To make this select group, a company needs to have:
- Paid a dividend for at least 25 consecutive years.
- Increased said dividend at least once every year during that time frame.
But that alone isn't enough. To get the very best Dividend Aristocrats, I suggest looking for companies that use less than 75% of their free cash flow (FCF) to pay out their dividends. FCF measures the amount of money a company brings in during a year, minus capital expenditures.
At the end of the day, it is from FCF that dividends are paid. If a company isn't using more than 75% of FCF to pay its dividend, it has wiggle room to maintain the dividend in tough times and the potential to continue its increases during good times.
AbbVie (ABBV +0.62%) is the perfect example of such a stock. It currently yields 3.6%, and has grown its dividend by 13% per year since being spun out of Abbott Labs in 2012. Here's an easy visual for how to figure its payout ratio from FCF, using 2015 FCF numbers on Yahoo! Finance.
Image and data source: Yahoo! Finance.
Do the math and you'll see that AbbVie used just 47% of its FCF to pay its dividend in 2015 -- making it an ideal candidate for a dividend lover's portfolio.
2. Don't forget about REITs and MLPs
But you don't have to limit yourself to just Dividend Aristocrats. There are two classes of companies that are designed for the specific purpose of paying out hefty dividends to investors.
|
Abbreviation |
Full Name |
Who It Applies to |
Rules It Must Follow |
|---|---|---|---|
|
REIT |
Real estate investment trust |
Companies that own or finance land that produces regular income streams |
Must pay out 90% of taxable income to shareholders |
|
MLP |
Master limited partnership |
Companies that are focused on extracting natural resources |
Though not a rule, these companies typically aim to use 87% or less of cash flow on dividends |
Data source: Securities and Exchange Commission.
There are a number of characteristics to look for in a successful REIT. Of course, it's crucial to have an understanding of the underlying properties that a REIT owns, and evaluate if you think the income from those properties will continue to grow or not.
For instance, if a REIT owns mall property, it would give me pause -- as malls seem to be a dying breed of retail. If, however, a REIT owns healthcare facilities, I would be very interested. Our aging boomer population will be using these facilities more and more in the coming years.
That's why I think HCP (HCP +0.61%), which currently yields 6.2%, is an example of a good REIT to consider investing in. The company owns senior housing, nursing, hospital, and medical office properties. Over the past 10 years, it has been able to increase its dividend by an average of 3% per year.
With MLPs, I consider the foremost metric to watch to be the coverage ratio. This is the amount of distributable cash flow (think of it as FCF for MLPs) divided by the dividend payment. In general, management teams aim for a coverage ratio of 1.15. This is the same as saying that no more than 87% of DCF should be used on the dividend. Any more and the dividend may be unsustainable.
One example of a solid MLP is Enterprise Products Partners (EPD +2.04%). The company owns thousands of miles of pipelines for both crude and natural gas transportation. Of course, the company is also beholden to energy prices, but it has performed remarkably well during the two-year plunge in commodity prices thanks in part to new projects coming online in timely fashion to maintain healthy DCF.
If you buy shares today, you get a company with a 6% dividend yield and a coverage ratio that sits at 1.3 through the first six months of 2016. In other words, only 77% of DCF was used on the dividend, which offers a fair amount of wiggle room for management.
3. Set up the DRIP in your Roth IRA
I know the abbreviations can be confusing. An IRA stands for an individual retirement account (either traditional or Roth). All you really need to know is that the dividends you are paid can be taxed if they are in a normal brokerage account. But if they are in a Roth, they'll never be taxed.
That's important for when you set up a DRIP -- a dividend reinvestment plan. You can set this up directly with your broker. When such a plan is in place, your account will automatically take any dividends paid to you and use them to buy fractional shares of the company it came from. Because these aren't taxed, the compounding effect can be enormous over time.
Nowhere is this more evident than an investment in Altria. The company's share price was held down for years because of litigation fears. But that made the dividend yield much higher, allowing DRIPs to repurchase big chunks of Altria's stock quarter after quarter.
The chart below demonstrates the difference between the 20-year return for Altria investors based just on the stock's price change and the effect of setting up a DRIP.
You definitely want the returns that the orange line provides. Setting up DRIPs for all of your dividend stocks will help you get there.
Don't stop with just the three stocks I suggested above. Use the guidelines to narrow your choices. Don't forget about MLPs and REITs, make sure the payout ratio is below 75% for your Dividend Aristocrats, and set up that DRIP!
