If you are an income investor and looking to invest for dividends, your stock portfolio will be markedly different from someone who’s investing for high growth and capital gains. The beauty about dividend investing is that you get to receive passive income in the form of dividends while at the same time, allow your stock to appreciate in value over time.
So if you investing for dividends, you want to pick only the best dividend stocks that give you the dividend income you want at minimal risk.
The question is: How?
Stable And Resilient Business
To find a good dividend-growth stock, investors must ensure that the business is stable and resilient. This means that the company should have a long history of profitability.
Since its founding in 1892, The Coca-Cola Company has became one of the largest companies in the world, cementing its position in the S&P 500. Coca-Cola manufactures, sells, and markets other non-alcoholic beverage concentrates, syrups, as well as alcoholic beverages
Coca-Cola has weathered many crises over the last few decades – The 1987 Black Monday, the 08/09 financial crisis, the 2020 Coronavirus pandemic… and for the most part, Coca-Cola has come out unscathed.
Crisis or not, consumers are likely to purchase beverages from Coca-Cola.
And even as more and more consumers become more health conscious, Coca-Cola has been able to continue its growth trajectory by adapting its products through innovation and brand building to fit the market needs.
Revenue and Net Profit
The best dividend stocks are usually large, mature companies with stable revenue, profits and cash flow. These companies have less growth left in them. Because these companies are no longer expanding aggressively, the majority of their earnings can be returned to shareholders as dividends.
Coca-Cola, Goldman Sachs, The Home Depot, etc.
Now obviously, slow growth doesn’t mean “no growth.” A company with deteriorating fundamentals (e.g. falling revenue, profits, cash flow, fading economic moat, etc.) cannot sustain its dividend payout in the long term.
For a company to pay investors a steady and growing dividend, it must still generate predictable and growing revenue and profits year after year.
Here’s a look at Coca-Cola’s revenue and profit. Despite its size, it is still on a steady uptrend; a testament to its stable and growing business.
On the other hand, you want to avoid companies in cyclical industries that earn uneven revenue and profit. A bad year could mean a drop or suspension in dividends.
For example, the oil and gas industry operates through cycles of shifting supply and demand, with these cycles resulting in swings in profit and losses. For example in 2020, McKinsey reported that the oil and gas industry is experiencing its third price collapse in 12 years — not great for investors looking for stability and a steady dividend.
If a company is large, stable and isn’t seeking to grow aggressively any more, then the majority of the profits it makes should be returned to shareholders.
If a company has a low payout ratio, ask yourself why the company is holding onto the cash. Unless they have a good reason to do so or have a way to generate exceptional returns for shareholders, the majority of profits should be paid out as dividends.
Long & Stable Dividend Track Record
The company should have a long and stable track record of paying consistent/growing dividends to shareholders. Since we are investing for dividends, we want companies that are able to pay us growing dividends year after year. No point in investing in a company that hoards cash and chooses to pay dividends inconsistently.
Go through the financials and see if a company pay a consistently growing dividend over the last 10 years. Coca-Cola for one, has been increasing its dividends over the last six decades!
Free Cash Flow Must Be Healthy
Ultimately, a company must have real cash (not just profits) to be able to pay dividends to its shareholders. Even if a company is profitable but has negative or inconsistent free cash flow, it will have trouble paying stable dividends.
Coca-Cola has been able to maintain healthy levels of free cash flow therefore providing the company the ability to maintain consistent dividend payments to its shareholders every year.
Now free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. In other words, you want to avoid companies requiring high capital investment levels to support and maintain their business operations.
The telecommunications industry is an example of such a capital-intensive business. Despite the rapid adoption of telecommunications devices (all of us use it for work, leisure, etc.), telecommunications companies spend billions of dollars — primarily funded by debt — to maintain and upgrade their infrastructure network.
Dividend Yield vs Risk Free Rate
Last, while not always, the dividend yield you receive should preferably beat the risk-free rate of the country you reside in. The risk-free rate is the lowest return you can theoretically get “risk-free” over a period of time.
In the U.S., if you plan to invest your money for 10 years, then the risk-free rate is usually based on the return of the 10-year U.S. Treasury note which is currently around 2.84%.
If your dividend yield can’t beat your risk-free rate, you might as well grow your money with the treasury notes since you face less risk growing your money there compared to investing in stocks.