Qualities Of The Best Dividend Stocks

Today’s article comes courtesy of frequent contributor Dave Van Knapp at SensibleStocks.com:

While there is no such thing as a “perfect” dividend stock for all investors, it is not difficult to identify the most desirable characteristics in any dividend stock. The top four are yield, consistency, dividend growth, and the potential for price appreciation.

Yield: It should go without saying that an ideal dividend stock ought to start off with a good yield. That is, on the day you buy it, the stock should yield at least as much as, say, a bank deposit. Extra yield helps compensates for the risk of owning a stock, whose price is never guaranteed and is therefore at risk.

That said, some leeway can be granted on the initial yield because the best dividend stocks increase their dividend payouts, unlike CDs and bonds, which are “fixed income” investments. So a stock whose yield falls a little short of a CD initially may catch and pass it in a year or two.

My personal requirement for the minimum initial yield from a dividend stock is 2.5%. I will go as low as 1.9% for “Dividend Aristocrats,” a term used by Standard & Poor’s for their list of stocks that have raised their dividends at least 25 consecutive years. At the end of 2007, the last time they compiled the list, there were 59 stocks that qualified. Perhaps surprisingly, not all of them yield at least 1.9%, so don’t assume that a steadily growing dividend “must be” high enough just because it is growing. The two are different factors that must be considered separately.

Consistency: The second characteristic is consistency (or reliability), not only in paying the dividend but in growing it too. There is no way to guarantee the future, of course, but we can draw reasonable inferences from past performance and current conditions. So, we want a company that displays:

  • An uninterrupted payment of a dividend for at least several years.

  • A steady history of raising its dividend most (if not all) years.

  • No severe financial difficulties that seem to threaten the dividend.

  • An explicit statement from management that they are determined to pay and periodically increase the dividend, or an implied intention based on the historical record plus current management statements recognizing the importance of the dividend.

My favorite company in the last regard is Realty Income (O). It states its purpose as follows: “As The Monthly Dividend Company® our primary goal is to provide dependable monthly income to shareholders.” As a dividend investor, you can hardly ask for a clearer statement of management’s intentions in regard to the dividend.

Dividend Growth: The third quality of a terrific dividend stock is dividend growth. It is a company’s ability to grow its dividend that separates it from “fixed income” investments like bank accounts and bonds.

As stated earlier, high yield and steady dividend growth do not necessarily go together. Some companies increase their dividends infrequently or erratically. On the other hand, the presence of high yield tells you nothing about dividend growth. So both factors must be investigated separately.

My personal benchmark for minimum acceptable dividend growth is 5% per year (4% for Dividend Aristocrats).

Again, we look to the past to draw reasonable inferences about the future. My “go-to” statistic is the stock’s annualized dividend growth rate over the past three years. It is not unusual to find rates of 15% or more. Often a stock’s dividend growth rate closely tracks the company’s earnings growth rate. I like that: It helps bolster my confidence that management will continue to direct a consistent percentage of earnings back to shareholders as dividends.

Yield and growth rate combine, of course, to determine the total dividend return to you. The math is simple. Say a stock is yielding 2.5% on the day you purchase it. If the company raises its dividend 15% per year, then in year two the yield on your initial investment will be 2.9%, in year three it will be 3.3%, and so on. Your personal yield will double in just under five years. (That’s why I’m willing to give a 0.5% break in initial yield to stocks that raise their dividend regularly.)

As an example, consider Sherwin-Williams (SHW). Its current yield is 2.3%, just a shade under my normal minimum. But it is on the Dividend Aristocrats list (more than 25 consecutive years of dividend increases), and it has grown its dividends 23% per year over the past three years. While it may not sustain that growth rate (its 2008 increase was 11%), let’s say we are confident in an annualized 12% growth rate for the foreseeable future. That means that the original 2.3% yield becomes 2.6% in year two, 2.9% in year three, and 3.2% in year four, all based on the original investment. Our original yield of 2.3% will double in about six years (based on the original investment).

Potential Price Appreciation: The first three factors focused on the dividend itself: its magnitude, reliability, and growth. The fourth important factor in a great dividend stock is independent of the dividend. It is the potential for the stock to appreciate in price.

This is another advantage that dividend-paying stocks have over bank deposits and bonds. To use the phrase again, the latter are “fixed income” investments. Not only is their income fixed, but so is their principal. At the end of a bond’s term, the principal is returned to you — ravaged by inflation. A stock, though, has a fighting chance to keep up with and exceed inflation. Historically, in fact, stocks do just that.

Some investors believe that a dividend stock’s price rises because of its dividend and increases to it. I don’t go that far. I believe that any stock’s price is determined by a host of factors, not all of them rational. Let’s just say that the stock’s dividend is one factor that many investors consider in deciding a fair price to pay for a stock. The important fact is that the stock has the potential to grow in price, just as its dividend does.

Don’t forget that any stock’s price has the potential to decline, too. To guard against that, any investor should do his or her normal homework to determine an advantageous valuation (price) to pay for any stock.

Disclosure: I own O and SHW.

You won’t find a clearer voice than Dividend Dave’s on the benefits of owning companies that regular pay profits to shareholders. Why, he even wrote a book about it and maintains an informative website free of jargon with nary a marketing gimmick in sight.

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