| Free Article |
Four Qualities of the Best Dividend Stocks
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
September, 2008
While there is no such thing as a "perfect" stock for all investors, I believe there
are four desirable characteristics in any dividend stock. What makes any stock
suitable for a particular dividend investor is how these characteristics are
blended in the stock.
"Dividend investor" refers both to investors who are pursuing high long-term
total returns by re-investing dividends as a principle tactic, as well as investors
(such as retirees) who are drawing off dividends as current income.
The four most important characteristics are:
• initial yield
• consistency and safety of dividend payments
• dividend growth
• the potential for the stock to appreciate in price
Initial Yield: An ideal dividend stock ought to start off with a decent yield.
That is, on the day you buy it, the stock should yield at least as much as, say, a
bank deposit. Higher yield helps compensate for the risk of owning a stock,
whose price is never guaranteed or insured.
That said, some leeway can be granted on the initial yield, because the best
dividend stocks increase their dividends regularly. That distinguishes them from
CDs and bonds, both of which are "fixed income" investments. So a stock
whose initial yield falls a little short of a CD may catch and pass it in a year or
two, because the company is increasing the dividend each year.
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. Not all of them yield at least 1.9%.
Therefore, don't assume that a steadily growing dividend must be sufficiently
high just because it is growing. The two are different factors that must be
considered separately.
Consistency and Safety of Dividend Payments: 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, current conditions, and intelligent projections.
So, we want a company that displays:
• Uninterrupted payment of a dividend for at least several years.
• A sustainable payout ratio. (The "payout ratio" is the percentage of
earnings that the company is directing to dividends rather than retaining for
reinvestment in the company.)
• 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, lacking that, an implied intention
based on the historical record plus current management statements that
underscore the importance of the dividend.
My favorite company in the last regard is Realty Income Corp. (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 an ideal 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 current yield and steady dividend growth do not
necessarily go together. Some companies increase their dividends infrequently
or erratically. Other companies increase their dividends regularly, but they don't
pay out very much of a dividend. So we must examine dividend growth
separately from the size of the dividend.
My personal benchmark for minimum acceptable dividend growth is 5% per
year (4% for Dividend Aristocrats). Ideally, I like to see a significantly higher
growth rate.
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.
As an example, consider Sherwin-Williams (SHW). Its current yield is 2.2%,
less than my normal minimum. But it is on the Dividend Aristocrats list, and it
has grown its dividends 23% per year over the past three years (all data from
Morningstar). While it may not sustain that growth rate (its 2008 increase was
11%), let's say we are confident in an annualized 15% growth rate for the
foreseeable future. That means that the original 2.2% yield becomes 2.5% in
year two, 2.9% in year three, and 3.3% in year four, all based on the original
investment. Our original yield of 2.2% will double to 4.4% in about five years
(based on the original investment).
Potential Price Appreciation: The first three factors focused on the dividend
itself: its initial magnitude, reliability, and rate of growth. The fourth important
factor in a great dividend stock is its potential 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 have done 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 history is one factor that many investors consider in deciding a
fair price to pay. The important fact is that the stock has the potential to grow in
price, just as its dividend does. Depending on your personal goals, you may care
a lot or just moderately about a dividend stock's price growth potential.
Everyone cares about the stock's potential to decline in price. To help guard
against that, be sure to do your normal homework to determine an
advantageous valuation for any stock you are considering. Try to buy at a price
which provides a margin of safety compared to your calculation of the stock's
fair or intrinsic value.
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
September, 2008
While there is no such thing as a "perfect" stock for all investors, I believe there
are four desirable characteristics in any dividend stock. What makes any stock
suitable for a particular dividend investor is how these characteristics are
blended in the stock.
"Dividend investor" refers both to investors who are pursuing high long-term
total returns by re-investing dividends as a principle tactic, as well as investors
(such as retirees) who are drawing off dividends as current income.
The four most important characteristics are:
• initial yield
• consistency and safety of dividend payments
• dividend growth
• the potential for the stock to appreciate in price
Initial Yield: An ideal dividend stock ought to start off with a decent yield.
That is, on the day you buy it, the stock should yield at least as much as, say, a
bank deposit. Higher yield helps compensate for the risk of owning a stock,
whose price is never guaranteed or insured.
That said, some leeway can be granted on the initial yield, because the best
dividend stocks increase their dividends regularly. That distinguishes them from
CDs and bonds, both of which are "fixed income" investments. So a stock
whose initial yield falls a little short of a CD may catch and pass it in a year or
two, because the company is increasing the dividend each year.
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. Not all of them yield at least 1.9%.
Therefore, don't assume that a steadily growing dividend must be sufficiently
high just because it is growing. The two are different factors that must be
considered separately.
Consistency and Safety of Dividend Payments: 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, current conditions, and intelligent projections.
So, we want a company that displays:
• Uninterrupted payment of a dividend for at least several years.
• A sustainable payout ratio. (The "payout ratio" is the percentage of
earnings that the company is directing to dividends rather than retaining for
reinvestment in the company.)
• 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, lacking that, an implied intention
based on the historical record plus current management statements that
underscore the importance of the dividend.
My favorite company in the last regard is Realty Income Corp. (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 an ideal 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 current yield and steady dividend growth do not
necessarily go together. Some companies increase their dividends infrequently
or erratically. Other companies increase their dividends regularly, but they don't
pay out very much of a dividend. So we must examine dividend growth
separately from the size of the dividend.
My personal benchmark for minimum acceptable dividend growth is 5% per
year (4% for Dividend Aristocrats). Ideally, I like to see a significantly higher
growth rate.
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.
As an example, consider Sherwin-Williams (SHW). Its current yield is 2.2%,
less than my normal minimum. But it is on the Dividend Aristocrats list, and it
has grown its dividends 23% per year over the past three years (all data from
Morningstar). While it may not sustain that growth rate (its 2008 increase was
11%), let's say we are confident in an annualized 15% growth rate for the
foreseeable future. That means that the original 2.2% yield becomes 2.5% in
year two, 2.9% in year three, and 3.3% in year four, all based on the original
investment. Our original yield of 2.2% will double to 4.4% in about five years
(based on the original investment).
Potential Price Appreciation: The first three factors focused on the dividend
itself: its initial magnitude, reliability, and rate of growth. The fourth important
factor in a great dividend stock is its potential 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 have done 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 history is one factor that many investors consider in deciding a
fair price to pay. The important fact is that the stock has the potential to grow in
price, just as its dividend does. Depending on your personal goals, you may care
a lot or just moderately about a dividend stock's price growth potential.
Everyone cares about the stock's potential to decline in price. To help guard
against that, be sure to do your normal homework to determine an
advantageous valuation for any stock you are considering. Try to buy at a price
which provides a margin of safety compared to your calculation of the stock's
fair or intrinsic value.
| SENSIBLESTOCKS .COM |
| Dedicated to the success of the individual investor |
| ||||||||||
| Click on cover image for description of product |