Financial independence has always hinged on the ability to create income. The basic principle is simple – your wealth should generate a return high enough for you to live on. The amount of wealth is just as important as the rate of return in this equation. There’s no denying that creating wealth has always been difficult, recently even returns have dwindled.
Low interest rates are the biggest threat to fixed income investors now. Generating a great return isn’t as simple as opening a savings account anymore. Interest rates in the developed world are at historic lows and are expected to remain at that level for a while.
So, fixed income seekers have been forced to turn to other options, namely property and dividend stocks. Savvy investors will realize dividend stocks are easier and less costly to manage than property. But then again it’s tricky finding the best dividend stocks.
There are thousands of stocks on the market and many of them don’t even pay a dividend. However, at last count over 418 companies listed on the S&P 500 paid a dividend. That’s 84% of the index. Why do these companies want to pay investors? Well, there’s two reasons. Firstly, dividend stocks have been getting very popular over the past decade. After the Financial Crisis, investors had to turn to dividends to supplement their fixed income. Secondly, dividends are really effective at providing return on investment. They are tax-efficient and have contributed over half of the S&P 500’s performance since the year 1928.
But not all dividends are created equally. 40% of the dividends on the market yield less than a 10-year US Treasury bond. Obviously, dividend rates need to be higher than a risk-free asset like a Treasury Bond to be considered. Then there are higher dividend yields that come with an added level of risk. The company could be in a volatile industry or have too much leverage on the books.
(Note: Do you want to build a long lasting portfolio of safe dividend stocks that produce a passive income? Our Free Dividend Guide contains the top 10 dividend paying stocks for the long term. Download yours now.)
Considering all the factors that allow a company to pay a dividend may help narrow the list down to the greatest dividends on the market. The best dividend stocks are the ones with most stable returns, and the best growth prospects. Here’s how to find the dividend gems in a crowded market:
Understanding Dividends
Before we jump into the search for the best dividend stocks, we need to step back and analyse where dividends come from. Dividends are essential paid from leftover cash. The company earns a profit at the end of each quarter, uses some of that money to expand the business and maintain assets, and pays investors whatever is left at the end.
Imagine you own a small business that makes bottles. At the end of the first year you have $100,000 in net profit. You decide to invest $40,000 in a new bottle-making machine so that you can sell more bottles next year and earn more profits. Then you pay yourself what is leftover – $60,000 – as a dividend.
That’s the same concept behind a payout from a major corporation. But with public companies you lack control over how much is paid out. So picking the best dividend stock is essential.
This link between profits and dividends tells you all you need to know about an income stock. A healthy dividend comes from a company that has the ability to create significant profits, invest the money appropriately and give back to the investors regularly. You must also understand that a dividend is big commitment from a company. Companies that cut their dividend rate after a while are punished by investors and lose a lot of their market value. For example, Potash (POT) cut its massive dividend twice in 2016, which pushed the stock price down 11% over the course of the year.
| Potash Corp of Saskatchewan Inc
POT:US 1 Year Return |
Cutting dividends is seen as a red flag. It shows that the company has issues with either profit or debt. Viacom Inc., for example, used a dividend cut this year to pay down its debt load.
On the other hand, a company that can consistently pay and grow its dividend over many years has proven its profits are sustainable.
What Makes a Dividend-Paying Company Great?
Profits, of course, are crucial; but a great dividend stock needs more than that. A company may not be able to create much value for anyone if the economic conditions of its industry are lackluster. Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Buffett said that right after losing the battle to keep the garment manufacturing operations at Berkshire Hathaway afloat. Garment manufacturing was moving overseas as cheap labor in overseas markets chewed away profits for local manufacturers. The economics of the business won out over Buffett’s ability to manage a company.
That’s true for all businesses. It doesn’t matter how great the CEO of a bank or oil producer is. If the oil prices and banking sector collapse, profits will fall and dividends will soon follow. A stable industry leads to more predictable returns. Investors need to have a clear view of how the future looks for the industry. The future must be somewhat predictable and relatively positive.
That doesn’t mean management isn’t important. Even in a great economic situation, bad management can ruin everything. Yahoo was the undisputed internet leader back in the early-2000’s. But the company was badly managed and even turned down the opportunity to buy Google for $1 million.
So a great dividend-paying company needs to be in an industry that has growth potential and great management. But debt is another issue that could complicate things. Even with a great leader and favorable markets, too much debt could prove risky. Leverage can ruin a company’s prospects very quickly.
Finally, great dividend stocks are usually companies that have a tight control on their cash flow. The biggest responsibility of a CEO is efficiently using cash generated by the company. This means the management has to cut costs, boost revenues, create profits, reinvest just the right amount and give back the rest to shareholders. The management is also responsible for leaving some headroom for dividend stability.
Reading through a company’s financial statements you’ll notice dividends are extracted from free cash flows. Free cash flow is money leftover after everything the company needs is taken care of (this includes reinvestment). All the cash is free, but management could decide to leave some in the bank account and give the rest back to shareholders as dividends. This gap allows the company to maintain the dividend at a steady pace by providing wriggle room. When times get tough, the company has enough of cash on the books to meet its needs. It doesn’t need to cut dividends. On the other hand, when times are better and profits rise, the company can comfortably increase the dividend without risking too much.
Comparing the amount of dividend to FCF is essential, but the usual proxy for headroom is payout ratio. Payout ratio is simply a ratio of dividends to earnings per share. It’s an easier metric to calculate and keep track of, which is why it’s so popular. A great dividend company maintains a stable payout ratio over a long period of time.
All these factors come together in a company that is a great dividend stock. Keeping these factors in mind while hunting for investments is the key to creating a rock-solid dividend portfolio.
How to Find Them
If you’ve taken the time to understand dividends thoroughly, it’s now time to start seeking them out. From a universe of thousands of stocks you need to filter out those rare gems you can hold onto.
To figure out the best dividend stocks, you need to apply everything you know about dividend-paying companies. However, investors are always prone to certain cognitive biases. It’s one thing to know what a good dividend looks like, it’s another thing to actually pull the trigger and buy the stock. The best way to avoid cognitive biases is to create a meticulous system. Discipline is the key to fighting off biases. Sticking to a checklist or a thorough system will allow you to execute your income-seeking strategy to its full potential.
Create a checklist of desirable qualities and then run through a stock screener to see which companies are left. Repeat this system again every quarter to see if your portfolio still holds up to the standards you’ve set.
Here is a step-by-step method to find the best dividend stocks on the S&P 500:
- Narrow down the list of 500 stocks to only the ones paying a dividend through a custom online screen.
- Cut the list down to stocks that have a dividend yield higher than the 10 year Treasury yield. At this moment, the 10 year Treasury yields 1.77%, so only stocks that have a yield higher than that can make the cut.
- You can narrow the list down further by setting the 5 year average dividend growth rate at 20% or higher.
- Narrow the list further by setting a reasonable bar for profit margins and return-on-equity, debt-to-equity ratios.
At this point you should have only a handful of stocks left. With these five steps out of the way you’ve managed to narrow down a list of more than 500 stocks to less than 100. But it’s not over yet. Now is the time to weed out the stocks that don’t have attractive intangible qualities.
To create a solid portfolio of the best dividend stocks, you must pick the companies you understand, which are part of a growing industry and have good management. Look for signs of ethical practices by managers. If they have a lot of their own money invested in the company and a good reputation for shareholder concern, you can think of them as safe bets.
Screening stocks to narrow down a list like this is quick and simple, but it isn’t for everyone. Some investors don’t see the point in narrowing down a list based on fundamentals when there are indexes that have already done this. Take for example proven blue chip companies.
The S&P 500 team narrows the list of stocks down to the ones that have increased their dividends every year for the past 25 years. This index has 50 constituents, all of which have a long track record of sturdy dividend growth. Here’s what the index breakup looks like:
An income-seeking investor could use this index as a starting point. Narrowing the list down further to pick a handful of stocks based on metrics we discussed above.
Or you could simply buy the index and hold onto it through the ProShares S&P 500 Aristocrats ETF. The Dividend Aristocrats have returned 8.32% over the past year, as compared to the S&P 500 which has returned only 6.43% over the same period.
Also, the Dividends Aristocrat Index isn’t the only index that focuses on dividends. There are three others, including the S&P Global Dividends Opportunity Index, the NASDAQ U.S. Dividend Achievers Select Index, and the Dow Jones U.S. Select Dividend Index. Each of these has special features that may or may not help you in your quest for the best dividend stock portfolio.
These indexes are created to help investors seek out income-generating portfolios. ETFs or exchange traded funds that track these indexes make it as easy as clicking a button to get started with a dividend portfolio.
But if you’re the sort of investor who likes to pick stocks, these indexes could provide a shortlist of the best. They provide a narrow field from which you can choose based on the criteria that appeal to you most. There’s a good chance you’ll recognize most of the companies listed. You may have used their products, heard of the brand or even worked for them. All this can help you narrow down a list of the creme de la creme.
Really good dividend investment tools can be hard to find. The one I use and like is Dividend Stocks Rock, you can use it to increase the overall return of your portfolio and help you retire faster and safer.
Examples of Great Dividend Stocks
It’s worth going over these methods to see which stocks turn up. The companies and industries that make it to the top of the list will most likely have a lot of features in common. Here are some of the best dividend stocks we could find after a thorough screening process:
Coca Cola Company
If you want an example of a great company, Coca Cola should probably be on top of that list. The company has a straightforward business model – sell soft drinks. Over the years the company has expanded its range and now owns 26 different brands. The company sells everything from drinking water to fruit juice. Being a global conglomerate, it even has brands and drinks you would have never imagined. The management has a stellar reputation and the company is also part of the Dividend Aristocrat Index. The company yields 3.3% in dividends currently.
Wal-Mart
The largest retailer in the world has an impact on the whole American economy. It employs hundreds of thousands of people and generates hundreds of billions in revenues every year. A reasonable profit margin allows the company to generate cash like a machine. Wal-Mart currently yields 2.92% in dividends. Add to that the share repurchase scheme that is currently ongoing and the total shareholder return comes to nearly 5%. The company’s biggest rival is now Amazon, the largest online retailer. Rising wages, competition from Amazon and aggressive retail pricing could all have an impact on the company’s bottom line. But with a proficient management team, an indestructible brand and a great business model, Wal-Mart has enough of ammo to keep it on top.
AT&T
AT&T yields nearly 4.45% in dividends. That is more than twice the rate offered by the S&P 500 (2%). Here’s the thing, telecoms are dividend generating machines. In the UK, Vodafone is one of the largest telecom company it yields more than 5%. Telecommunications require large investments in equipment and spectrum licenses. But once the company has laid down the cash, they can collect handsome returns for many years. Call rates, data charges and text messages are all services with great profit margins. This cash is returned to shareholders in the form of dividends. AT&T currently has enough of headroom – 1.48%, and it’s free cash flows have been grown 7% over the past year. It’s a healthy dividend-paying stock.
The ability to generate cash and manage it properly is what makes these three companies different from the rest. There are a lot of companies that yield higher dividends or have stocks that have performed better over the past year. But this list should serve as an example of companies that can deliver stable and healthy returns.
Conclusion
I’ve always thought of investing as planting trees. You have to take the first step and plant the seeds, wait for the plant to grow and nourish it properly throughout. When the tree is big enough, it starts growing fruits which you can eat every year for the rest of your life.
Dividends from companies are an apt analogy. The company needs to be strong and stable enough to offer ongoing dividends. To find the best dividend stocks, it is imperative that you understand how dividends work and where they come from. Once you’ve established the link between profits and dividends, you’ll see that the best dividends come from the companies that have the most profit potential.
But high profits and yields are simply not enough. The economic conditions, business model and management all need to be stable. Lower debt and better cash management are really crucial. A true dividend gem has a combination of all these qualities.
Companies operated by trustworthy managers that can generate cash regardless of market conditions are the most likely to give back to shareholders. A strategy designed to find such profitable and stable companies will help you create a rock solid dividend portfolio. Depending on the size of your wealth, the income from this portfolio should be more than enough for you to live on.
(Note: Do you want to build a long lasting portfolio of safe dividend stocks that produce a passive income? Our Free Dividend Guide contains the top 10 dividend paying stocks for the long term. Download yours now.)
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