It’s always fun to get paid for being a shareholder. Under the best conditions, dividend stocks provide regular income that you can count on for years. But if you pick a weak contender, you might not even have an opportunity to make your money back.
So, if you want to supercharge your returns, you’ll need to pick dividend-bearing investments quite prudently. Today, I’ll be sharing three tips that should get you on your way to building a robust income stream from your holdings.
1. High yields can be a warning sign
One mistake that dividend investors may be tempted to make is buying a stock on the basis of its spectacularly high dividend yield. When you see a high yield, it’s important to proceed with caution, because the yield may be the result of a larger story that’s relevant to the stock’s merit as a part of your portfolio.
There are a couple of ways that the dividend yield of a stock can rise, and they’re both rooted in simple algebra. One way is when management decides to increase the size of the dividend payment, which makes it larger in comparison to the stock’s price.
Another way is for the stock’s price to fall while the dividend payment remains constant. And for dividend yields in excess of 10%, especially when you’re looking at a company that isn’t a real estate investment trust (REIT), it’s the second of the two options that is often the explanation for the attractive yield.
Thus, stocks with very high yields are commonly stocks that recently lost a lot of their value as a result of poor earnings or some other unfavorable development. That doesn’t mean you should never buy them, but it does mean that you will need to identify and understand what’s going on and how it relates to the company’s ability to be a good investment over time.
Of course, if you find that there’s actually nothing wrong and there’s just been a large hike in the payment or the announcement of a special dividend, it’s a positive sign rather than a warning.
Finally, it’s worth noting that some of the all-time great dividend stocks have relatively low dividend yields — like Abbott Laboratories (NYSE:ABT), currently clocking in at around 1.4%. So, don’t let a low yield dissuade you in the same way a high yield might.
2. Look for consistency and growth
There’s not much point in buying a stock for its dividend if it only pays erratically. Likewise, if you buy dividend stocks that don’t ever raise the size of their payments, in the long run the dividend’s value will get eroded by inflation.
One way to filter out stocks that don’t meet the cut is to look at the history of the business’ dividends, which you can usually find on the investor website. A payout that rises one quarter only to fall or be absent in the next quarter isn’t one that you should be counting on.
A great way to screen for both the consistency and growth of dividends is to look at a list of the Dividend Aristocrats. The Aristocrats are major companies (like Abbott Laboratories) that have increased their dividend payments each year for at least 25 years consecutively.
So, you can likely count on them to keep paying out — and increasing those payouts over time. If you’re willing to invest in a company with a shorter payout history, there are less stringent categories of dividend royalty, like the Dividend Contenders, which have between 10 and 24 years of consecutive increases.
If you’re a conservative investor, there are also stocks that are part of the even more exclusive Dividend Kings list, such as Johnson & Johnson (NYSE:JNJ). These stocks have more than 50 years of dividend growth.
3. Sustainability is key
Even with Dividend Kings, you need to be vetting the sustainability of the dividend — that is, the ability of a company to successfully compete in its markets and grow while at the same time reward its shareholders with a dividend. For highly ranked dividend-paying businesses like Abbott Laboratories and Johnson & Johnson, investors tend to have a great deal of confidence in their sustainability.
Simply being able to pay a dividend through the next year or so does not guarantee that shareholders will continue to get what’s due. Declining companies can theoretically liquidate productive assets or take out debt to avoid cutting the dividend, for a time. But robust and growing businesses can expand their balance sheet while increasing their dividends too.
For me, the biggest metric to look at regarding dividend sustainability is growth in a company’s free cash flow (FCF) over time, which both Abbott and Johnson & Johnson have in spades. Rising free cash flow is usually the product of diligent management and an effective business model, generally speaking. If over the years there’s a steady trend of having more free cash flow with each quarter that passes, the company is probably healthy enough to keep paying out its dividend. On the other hand, a downward trend could point to cuts in the future, so it might be worth avoiding.
It’s also not a good look when companies prioritize investor returns over the long-term health of the company. Remember, every dollar paid out in the form of dividends is a dollar that management doesn’t have the opportunity to deploy at an attractive rate of return to grow the business.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.