7 tips to pick dividend stocks

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below:

To pick the best dividend stocks, look out for:

Mid- to large-cap stocks with dividend payout ratio of 50% or more.

Track record of consistent dividends.

Companies with sustainable fundamentals, low capital expenditure, and stable cash flows.

 

HELP FOR THE INCOME INVESTOR

As investors, we all love dividends. Other than the thrill of seeing a stock you own rise higher and higher in the stock market, receiving dividend income from your investments every year is something we all look forward to.

So if you’re more of 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 gain. The stocks that will give good, consistent dividends may not necessarily be the kind that enjoy strong capital gains, and vice versa.

So how do you go about picking dividend stocks? Here are 7 quick tips to help you pick dividend stocks from what’s around: (Hint: You can’t just look at dividend yield alone!)

A category of dividend stocks that tend to be popular are usually mature companies with stable revenue, profits and cash flow. Often, these companies are not high-growth businesses.

Indeed, high growth sucks up a lot of cashflow for expansion, often leaving little for dividends. Because more mature companies are often not expanding aggressively, most of their earnings can be returned to shareholders as dividends.

Conversely, smaller, high-growth companies need more cash and resources to grow and expand their businesses, leaving less cash to pay shareholders dividends.

The dividend payout ratio is the percentage of a company’s earnings paid to investors as cash dividends. It is an indication of the sustainability of a company’s dividend payment stream.

If a company is large, stable and isn’t seeking to grow aggressively any more, then the bulk of the profits it makes should be returned to shareholders.

There are no universal benchmarks for the ideal payout ratio. Dividend seeking investors would want a high payout ratio – and that can range from above 40-50%, depending on who you talk to. But you also don’t want a payout ratio so high (say 80%) that the company is vulnerable to cutting dividends in the event of earnings decline.

If a company has a low payout ratio, ask yourself why the company is holding on to 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.

So, perhaps the sweet spot can be a payout ratio of (roughly) between 50-70%.

The company should have a long and stable track record of paying consistent/growing dividends to shareholders.

Dividend investors will get no joy from a large and successful company – with profits to distribute – if the company chooses to pay dividends inconsistently.

So check to see that the company is paying a consistently-growing dividend over the last five to 10 years. This shows that as the company grows more successful, the management is also willing to share the fruits of its labour with its shareholders.

Many dividend investors tend to ignore the overall aspects of a company’s fundamentals. They choose to focus primarily on the amount of dividends they can receive.

This can be too narrow a focus. While the yield is obviously important for someone seeking dividends, it is also important to consider the overall health of the company.

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. The less revenue and profit it makes, the less dividends it can pay.

Over time, a company with falling revenues and profits will see its stock price fall when investors realise that the company is no longer performing. This fall in value will eat into any dividend gains you might have had at the start – leaving you back at square one.

So always make sure the dividend company you want to invest in will remain fundamentally strong and robust for many years to come.

As a dividend investor, you might prefer to invest in a company with low capital expenditure (CAPEX) commitments and plans.

A company with high CAPEX is continually reinvesting its profits to expand its business, which leaves less to distribute as dividends. For example, airlines have very high CAPEX as they need to continually maintain and upgrade their aircraft fleets.

So if you’re looking for dividend stocks, look for a company that’s able to maintain/grow its business with minimal CAPEX requirements.

Ultimately, a company must have real cash (not just accounting profits) to be able to pay dividends to its shareholders.

A company can show accounting profits but suffer negative or inconsistent free cash flow. Such companies will have trouble paying stable dividends.

A smaller company that is seeking to grow might have negative free cash flow as it expands its business. But a large, stable company that dominates its industry should be more able to produce strong free cash flow consistently.

The dividend yield (a stock’s annual dividend as a percentage of its share price) you receive should 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 US, 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 US Treasury note which is currently around 1.62%.

In Singapore, the risk-free rate is the lowest return you can get for very low-risk instruments, such as the Singapore Government Securities, a type of government bond.

This article, which first appeared on The Fifth Person, is reproduced with edits and permission.


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