3 Things I Look For In Dividend Stocks
Updated: Jul 3, 2020
Part of my portfolio has been dedicated to dividend stocks. As I get older, my intention is to shift a larger portion of my portfolio into stocks that are relatively stable and pay dividends. The key reason for this is obvious, at some point in the future, I want this portfolio to give me regular returns automatically without me having to actively check prices and move my stock positions.
The objective of this post is to share what I look for in dividend stocks so that anyone starting out in investing can have an easy starting point and understand what dividends are and how to analyse them. I also want to make a disclaimer at the very start that these are the metrics that suit me. Neither are these the not the only things you can look when considering dividend stocks. There are various other sophisticated methods which experts have come up with which would be more suitable for advanced investors.
What are dividends?
Simply put, dividends are part of a company’s earnings that are distributed to its shareholders. There are different types of dividends paid out to different classes of shareholders, but the most basic ones come in the form of cash or stock that and are distributed quarterly. When you are purchasing a dividend stock, there are 2 important dates to take note of. First is the Ex-dividend date. This refers to the cut-off date for a specific period’s dividend. Anyone holding a stock before the ex-dividend date will be entitled to dividends. It is important to note that when a dividend is announced, the stock price of the company usually increases or decreases proportionately to take into account the dividend payouts. The second date is the Payout date. This is the date you receive the dividend payout from the company.
Why do companies pay dividends?
My first reaction to this question is “Why not?”. When you own a stock, you own a very small piece of the company, which makes you one of the shareholders. When the company makes a profit, it should be quite normal to distribute the profits to its shareholders. Dividend payouts are a way of measuring the company’s performance and to keep its shareholders happy.
However, there are some valid reasons why a company may choose not to pay dividends. The biggest example of this is Amazon. Despite being one of the largest companies in the world, Amazon has never paid out a dividend. Instead, they re-invest the profits earned back into the business to fuel even more growth. In Amazon’s case, history has shown that this strategy is every effective in increasing the stock price, which is also a form of returns to the shareholder. Because these companies keep its shareholders happy through rapid growth, they are justified in re-investing their profits instead of distributing them.
In the long run, the companies do end up paying dividends. That’s because after a point, rate of return on reinvestment slows down, and it might be better to start distributing the profits to the shareholders.
How do I assess dividend stocks?
Now I will go through the first 3 things I look for when I am choosing my dividend stocks.
There are other factors like the company fundamentals which are very important. But these fundamentals not unique to dividend stocks and should be considered in any kind of investing anyways.
Dividend yield is basically the portion of the stock price that you receive in the form of annual dividends. The formula is very simple: Annual dividend / Stock Price at purchase.
Dividend yield is very sensitive to price. If someone bought the stock at a lower price than you, then their yield will be higher for the same amount of dividend. This means that assuming the stock price appreciates over time, your dividend yield will get higher and higher and because of this reason, dividend investing is very attractive to long term investors.
Personally, I tend to choose companies that pay between 4% to 8% dividend yield. Obviously higher yields are more attractive, but when the yields are too high, you need to research more and find out what is driving the high yield.
These are some of my dividend stocks. If the dividends are increased over time, my yield will also increase because the price I paid for them remains fixed. Therefore, dividend investing is a long term game. The earlier you start, the more value there is to be gained.
Obviously due to the stock market crash, the prices have gone down. And hence the dividend yields now look very attractive. Though it has to be noted that because of the market and the recession, the dividends might also go down. So, we move to the next factor – dividend history.
In my opinion, looking at a company’s dividend history is a very important indicator. As dividend investing is a long term strategy, I only want to invest in companies that have consistently increased or maintained their year on year dividends. This might seem like a “greedy” ask, but a lot of large cap companies are able to maintain their dividends even during periods of downturn. Doing so also increases my confidence that the company is here to stay for the long run and I feel more comfortable investing in them.
This is the dividend history of AT&T (T) from the 1990s. Notice that even during the dotcom bubble burst in 2000s and the financial crisis in 2008, the company was able to maintain the quarterly dividend. This is the kind of pattern I personally look for.
In contrast, this is General Electric’s dividend history. This is also a large company but looking at the dividend history will give any dividend investor sleepless nights. Thus, strictly from a dividend investing point of view, this is the kind of pattern to avoid.
So, its pretty simple right? Find a company that pays high dividends, and if it has been consistently doing so, then it’s a great company to keep for the long term? Unfortunately not. There are companies out there who have some great numbers and fundamentals, however are not suitable for a new dividend investor. Note I specified “new dividend” investor because I am sure there are investors out there who have held these stocks for a long time and enjoyed their dividends.
Payout ratio is the proportion of earnings that is used to pay dividends. A healthy payout ratio in my opinion is from 20%-50%. Basically, a good amount of the profits are paid back to shareholders, and it also leaves a considerable amount for reinvestment to grow the company. In some industries the payout ratio can go up to 70% because there is little growth left in that industry and the companies are basically just fending off competition.
Lets take an example of the tobacco company Philip Morris International (PM). It is currently giving a dividend yield of 7+% and its average yield in the last 3 years was 6+%. That’s a great return. Its dividend history has also been consistently increasing.
But I would stay away from this as a dividend stock. If we look closer, PM’s dividend payout ratio is extremely high at about 90%. This means that PM does not have any funds to grow the company and is distributing everything to the shareholders to keep interested. For me, that is not a good sign for the long term as it indicates that the company has already peaked and the only way left is down.
Another example would be Procter and Gamble (PG). In 2015, PG’s dividend payout ratio went above 100%. This essentially means the company had to pay its shareholders more money than it earned that year. PG did this because there was pressure to maintain their dividends but to me, this is equivalent to dropping its dividends because they were forced to distribute more than they earned.
While such stocks with high payout ratios might work for some investors, but to me, it does not show confidence for the long run.
Basically, these 3 metrics help me to filter out the stocks that I am considering to add to my dividend portfolio. Of course, there are more factors to consider before finally buying. Right now, with all the prices depressed, there are some potential gems out there if you are able to pick correctly.
Disclaimer: This post should not be interpreted as investment advice as I am not a professional financial consultant. The objective of this blog is to share my experiences with others and receive feedback. I will provide links to my information sources to the best of my abilities, but the reader is responsible for their own due diligence