Dividend-paying stocks are the bread and butter of our portfolio. Preferred stocks can provide consistent income, and some fixed income investments offer more security, but the wide, wide world of dividend-paying stocks will always be our first love. In today’s Dividend School, I tell you exactly what I look for in dividend-paying stocks, whether they’re joining the High Yield, Dividend Growth or Safe Income tiers of our portfolio.
• Dividend History – The first requirement for any Dividend Investor recommendation is an impressive dividend history. A long and consistent history of paying dividends—and, even better, increasing dividends—tells me both that the company consistently generates enough cash to reward shareholders, and that management is committed to prioritizing shareholder returns.
You don’t want to see any dividend cuts, especially recently. Cuts suggest that either the company’s cash flow isn’t reliable or predictable, or that the company distributes dividends it can’t afford.
• Cash Flow – While dividends are a good sign of consistent cash flow, looking at income itself is equally important. For most businesses, I use free cash flow, or FCF, as the best indicator of available funds. Free cash flow simply equals operating cash flow minus capital expenditures. In other words, it’s what’s left of income after the company spends what it has to. That number is important because, when all is going well, it’s where the money for dividends comes from. (Companies that can’t afford to pay their dividends out of free cash flow are forced to either cut them or find the money elsewhere, which is usually only a temporary solution. You can tell this is happening by comparing free cash flow to dividends paid.)
Companies with strong free cash flow can also invest in growth, make acquisitions and repurchase shares. In the Dividend Growth tier of our portfolio, EPS and FCF must both show consistent growth (and it’s a bonus in other tiers).
• Payout Ratio – The payout ratio links the two pieces of information above, telling you how much of its earnings a company is giving to its investors. Most websites report the payout ratio as the stock’s annual dividend payment divided by its earnings per share (EPS), but I also calculate payout ratios based on FCF, mentioned above.
For example, a company that reported EPS of $3.00 per share in 2014 and made four quarterly dividend payments of $0.20 each (for a total yearly dividend of $1) would have a payout ratio of 33%.
Ratios in the range of 20% to 50% are usually considered good, although higher or lower payout ratios can be acceptable depending on the business the company is in, how mature the company is, and other factors. In addition to looking at the payout ratio on its own, I also compare the current payout ratio to the company’s historical payout ratio, to see if the company’s earnings and dividends are growing at the same rate or if one is outpacing the other.
The primary red flag to watch out for when looking at payout ratios is a number that’s too high. With some exceptions for MLPs, utilities and other entities created specifically to pass along cash to investors, the payout ratio should generally show that the company has some cash left over to put back into the business, buy back shares and create a cushion for leaner times ahead. A company handing over 90% of its earnings to shareholders, in other words, may have a hard time affording that same payment down the road. Younger, faster-growing companies generally hold onto more of their income for growth and stability than older, slower-growing companies that may feel the best use for the money is paying back shareholders.
• Story – The three factors above give me the most direct, unfiltered look at an investment’s ability to continue rewarding investors through dividends and long-term growth. But I also consider less quantitative factors to pick the best of the qualifying investments for Cabot Dividend Investor. These factors are usually put forth in the section of each recommendation titled “The Company.” Plusses include a business model that generates steady earnings and catalysts for growth at the company or in the industry. For example, this month’s recommendation, Equifax, is benefiting from growing demand for consumer data, and also driving growth by expanding its offerings.
Companies can also be eliminated based on “story” factors, even if they have strong earnings numbers and long dividend histories. For example, stocks that have a strong dividend history but are in shrinking industries, like newspapers, will be eliminated at this step.
• Additional Factors – Depending on which tier I am considering an investment for, I may also consider additional quantitative and qualitative factors.
In investments I’m considering for the Safe Income tier, relatively low volatility is important. To assess volatility, I look at stock charts, consider the stock’s beta (< 1 means less volatile than the benchmark, > 1 means more volatile) and research industry factors. Established businesses in growing or stable industries are much less volatile than smaller companies and those in more cyclical industries. Longevity is also a concern—the company and its industry must both be viable long term, and stocks in faddish industries, like 3D printing or social media, are simply inappropriate.
In the Dividend Growth tier, I require a company to demonstrate above-average earnings growth, and I also like to see company-specific or industry-wide catalysts for more growth. And in the High Yield tier, of course, the investment’s current yield must be significantly above average.