Dividend stocks are undeniably attractive to almost every investor. Whether you’re looking for regular income, a healthy return, substantial capital gains, or even a lifelong investment, dividend stocks rarely disappoint.
Part of what makes them so attractive, as we’ve discussed before, is the way these stocks behave. Dividend stocks act like a mix of fixed income and equity securities. That means they offer a steady rate of regular income (like a bond would) while also offering the opportunity to participate in the company’s growth (like a common stock would).
Despite the simplicity of these instruments, many investors are still puzzled about dividend investing. Some investors see dividends as a waste of money by corporations that are out of ideas. They argue that the management of the company should be able to use the money to invest in future growth. Others see dividends as a sign that the company has either stagnated or in decline. Most investors simply don’t trust stocks, expecting companies to suddenly cut dividends and experience a drastic loss in value.
All these concerns are justified. Energy companies, for example, cut their dividends when the price of oil collapsed in 2014. Retail stores and old-school tech companies have been returning cash to investors instead of using it to acquire new, innovative companies to grow. Dividend stock investing is a simple concept, but the execution is complicated and most investors have no idea where to buy dividend stocks and how to judge quality.
So, here is a six-step strategy for finding the best dividend stocks:
Step 1. Determine your dividend yield
Before you can think about where to buy dividend stocks, you need to set your objectives. The most obvious objective is the dividend yield. Stocks that pay a dividend set a regular rate for their annual payments. If you bought a $100 share and the dividend paid out over the course of a year was $10, the dividend yield is 10%. Managers usually decide this dividend rate based on their expectations of future growth, the amount of money they feel they need to invest to keep the company growing, and the rate of dividend they can afford every year.
For most dividend stocks, the yield is pretty consistent. Companies are rather reluctant to cut the dividend rate, which means the yield is sticky over time. You need to pick the appropriate yield based on opportunity costs. In other words, you need a yield that is higher than other savings instruments like bank savings accounts and government bonds. Considering the rate of interest on a 10-year Treasury bond today, you should aim for a dividend stock that yields more than 2.5% a year.
Step 2. Screen For The Right Stocks
Next, you want to screen all the available dividend stocks based on certain criteria. Simply investing in the highest yielding dividend stocks is a recipe for disaster. Some companies borrow to fund their dividends which is a risky strategy. Others have higher than average dividend yields because the stock price is rapidly collapsing.
To secure your investments, run a screen to narrow down the list of stocks based on debt-to-equity ratios, dividend coverage ratios, profit margins, and return on equity. Also, look for stocks that have a long history of dividend payments, dividend increases, and earnings growth.
Step 3. Narrow The List
Once you’ve narrowed down a list of stocks based on the specific ratios and key metrics, you need to cut the list further with a little qualitative analysis. In other words, look for stocks for companies you understand well. Pick out companies that are likely to perform well considering their industry and the economic forecasts. Study management’s behavior and figure out if the company’s management has a history of acting in shareholders’ best interests. Only pick stocks that have a profitable business model, that’s easy for you to understand and is protected by a competitive advantage that can endure the test of time. Above all else, pick companies that are run by competent and ethical managers.
Step 4. Value Each Stock
At this stage of considering where to buy dividend stocks, you need to figure out the value of the narrow list you’ve created. From a universe of thousands of different companies, you probably have a list of less than twenty stocks that fit all the criteria we’ve covered over the past three steps. Each of these stocks is worth investing in, but you can’t move ahead unless you know you’re getting a good deal. You need to value each stock individually, and figure out if the current price on the market is above or below the stock’s intrinsic value. For stable, dividend paying stocks, we recommend either the Gordon Growth or Dividend Discount models for stock valuation. Remember to leave a margin of safety while investing.
Step 5. Create A Dividend Portfolio
At this stage, you probably have a list of undervalued, dividend-paying gems. You can consider investing in all the companies that have passed through the previous filter, but each of them needs to fit into your portfolio. You need to diversify your holdings, which means you can’t have a disproportionate amount of money in any specific company or industry. Try to invest in more than 10 stocks, making sure that all of them are part of different industries and have different business models. Try to make sure that no company constitutes more than 25% of the entire portfolio.
Step 6. Measure Performance
Finally, the best way to improve and evolve your strategy is to measure your performance regularly. Check the performance of your portfolio and compare the returns to the index. If the returns are higher than the S&P 500 or Dividend Aristocrats Index, you’ve done a good job and you can keep repeating these steps to maintain the portfolio. If not, consider making changes to your strategy.
Dividend stocks are spectacular. They tend to strike the perfect balance between ready, regular income, and long-term capital gains. With well-picked dividend stocks, not only can you participate in the company’s growth over time, but the company will actually pay you meanwhile to hold on.
But most investors still wonder where to buy dividend stocks. Picking the best companies and creating a rock-solid dividend income portfolio is easier said than done. If you follow the six steps laid out here and take the time to dig deeper and learn more about this investment style, you’ll improve your performance and sustain wealth creation over time.