By The Fifth Person on December 28, 2015
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 passive 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 will grow by 20-50% a year and vice versa.
So if you investing for dividends, you have to invest accordingly and only pick the best stocks that will give the passive dividend income you want. The question is: How?
Over the years, our investments have received more than 5-figures in dividends. So if you’re slightly lost and looking for some direction, here are 7 quick steps that we personally use to pick the best dividend stocks around: (Hint: You can’t just look at dividend yield alone!)
#1 Look for Mid-Large Cap Stocks
The best dividend stocks are usually large, mature companies with stable revenue, profits and cash flow. These companies have little growth left in them. Because these companies are no longer expanding aggressively, the majority of their earnings can be returned to shareholders as dividends.
On the other hand, a smaller, high-growth company needs more cash and resources to grow and expand its business, leaving less money to pay shareholders dividends (if any).
#2 Dividend Payout Ratio is 50% or More
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. So look for a company with a dividend payout ratio of at least 50% or more. For example, Nestlé (Malaysia) returns over 90% of its earnings to shareholders as dividends.
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.
#3 Track Record of Paying Consistent Dividends
The company should have a long and stable track record of paying consistent/growing dividends to shareholders. No point if a company is large and successful and has profits to distribute as dividends, but chooses to pay them out inconsistently.
The best track record is to see a company pay a consistently growing dividend over the last 5-10 years. This shows that as the company grows more and more successful, the management is also willing to share the fruits of its labour with its shareholders.
#4 Company’s Fundamentals Must Be Sustainable
Many dividend investors tend to ignore the overall aspects of a company’s fundamentals and primarily focus on the amount of dividends they can receive from an investment. While dividend 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.
Furthermore, a company with falling revenues and profits will see its stock price fall in tandem over time as investors start to realize the company is no longer performing as well. 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.
#5 Company has Low CAPEX
As a dividend investor, you prefer to invest in a company with low capital expenditure (CAPEX). A company with high CAPEX means that it has to continually reinvest its profits in maintaining its business operations, leaving less to distribute as dividends.
For example, airlines have very high CAPEX as they need to continually maintain their aircraft and upgrade them to newer models after a certain amount of years.
So look for a company that’s able to maintain/grow its business with minimal CAPEX.
If you want help, you can always kick start the idea by downloading our watchlist of dividend paying stocks below:
#6 Company has Stable Free Cash Flow
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.
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 producing high amounts of free cash flow year after year.
#7 Yield Must Beat Risk-Free Rate
The dividend yield you receive from a stock 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 ten years, then the risk-free rate is usually based on the return of the 10-year US Treasury note which is currently around 2.30%. In Malaysia, the risk-free rate is usually based on the guaranteed interest your EPF gives you which is 2.5%. However, since 2000, EPF has been able to give out between 4.25% to 6.75%, which is more than the minimal guaranteed.
If your dividend yield can’t beat your risk-free rate, you might as well put your money with the US Treasury / EPF since you face less risk investing in a US Treasury note / EPF than investing in a stock to generate the same returns.
The Fifth’s Perspective
There you have it! Seven quick steps to help you pick the best dividend stocks to invest in. As you can see, there are lots more items to consider other than just dividend yield!
So remember to check these seven criteria whenever you’re looking to invest for dividends.