The silver lining of market panics like Brexit is that they make stocks with good support stand out like beacons in a sea of red. But as long-term investors, technical support isn’t our main criterion for stock selection. That would be IRIS, our Individualized Retirement Income System, and the Dividend Safety and Dividend Growth Ratings it assigns to every stock in our universe.
Here’s a refresher on the qualities that help a stock pass our tests for inclusion in the Cabot Dividend Investor portfolio.
Dividend History
The best way to find good dividend payers is the simplest: look for stocks with a good history of paying dividends. IRIS gives high marks to companies that have been paying regular dividends for many years without skipping dividends or reducing their dividend amount. A long history of paying dividends indicates both that management prioritizes paying dividends and that the company’s business model can sustainably support regular dividend payments.
Dividend cuts or skipped dividends are evidence that business is too cyclical, unstable or unpredictable for our model. They can also reveal a management team that’s unrealistic about declaring dividends, trying to stretch to pay dividends it can’t afford.
Our Dividend Safety Rating tells you how safe a company’s dividend is—how likely it is to be maintained at the current level at least—so dividend history is the most important component of this rating.
Payout Ratio
Our Dividend Safety Rating also takes a company’s payout ratio into account. The payout ratio is the percentage of earnings paid out as dividends, calculated by dividing the stock’s dividend per share by earnings per share (EPS). I also like to calculate payout ratios based on operating income or free cash flow, since EPS can be affected by non-cash expenses (and dividends are paid from and in cash).
A low payout ratio is good: it shows that the company’s dividend payments are well covered by its earnings, so they’re not in danger. In addition, it means the company is holding plenty of cash back to reinvest in the business, ensuring the security of future dividend payments.
A high payout ratio can be a red flag that a company is having a hard time affording its dividend payments, especially if the payout ratio is historically high for the company. Companies that pay out a large percentage of their cash also have less cash to reinvest in growing their business.
Some companies can maintain higher payout ratios than others, so rather than looking at the payout ratio in a vacuum, I compare it to the company’s historical payout ratios and look at which way the payout ratio has moved over time. (Note that some types of businesses, like MLPs and REITs, will always have very high payout ratios (often over 100%) and need to be evaluated differently.)
History of Dividend Increases
The best indication of future dividend growth—which is what our Dividend Growth Rating measures—is a history of dividend increases. IRIS ranks stocks on their history of dividend growth, granting the highest marks to companies that have paid higher dividends every year for many consecutive years.
Some companies in our database have increased their dividend every year for decades. Others have only begun to prioritize dividend growth in the last few years, or have had to start rebuilding their dividends after cutting or suspending them in 2008. A company that has increased its dividends every year for at least the past three years makes it into the top quartile of stocks under this ranking.
Dividend Growth Rate
The dividend growth rate measures how much a company has increased its dividend each year. We consider five- and 10-year dividend growth rates when evaluating companies. Holding stocks that consistently increase their dividends by a significant amount is the best way to secure a growing stream of income.
A five-year dividend growth rate of at least 10% will earn a stock a place in the second quartile of our dividend growth rankings, but plenty of stocks increase their dividends by much more each year. Annual dividend increases of 20% or more will secure you quite a nice income stream indeed.
Sometimes when discussing growth rates I will mention a CAGR. This stands for compound annual growth rate and is a way of annualizing growth over a multi-year period. If I say a dividend grew at a 16% CAGR, that means it grew 16% per year on average—though it may have grown more or less than 16% in each individual year.
Earnings Growth
Dividends are paid out of cash flow. If cash flow doesn’t grow, dividends can’t grow. That’s why I consider earnings estimates when rating stocks for dividend growth potential. I want to see future EPS estimates that are higher than current EPS, ideally by double-digit percentages for stocks with the highest Dividend Growth Ratings.
I also look at a company’s history of EPS growth, although consistent free cash flow and operating income are more important to me, because they’re more transparent measures of cash coming in (which directly affects how much cash can be paid out).
IRIS Ratings and Your Portfolio
IRIS ratings’ importance to you will vary based on your investing goals.
If you’re looking to build a portfolio of stocks to hold for the long term that will generate a reliable income stream, Dividend Safety Ratings are a great way to screen for dividends that are unlikely to go down.
If you’re younger and care more about having a portfolio that will deliver total return now and higher yields in the future, Dividend Growth Ratings give you a good indication of which dividends are most likely to increase.
And of course, if high yield is your number one goal, you’ll want to choose stocks with high yields, but our IRIS ratings can still help you. The Dividend Safety Rating will give you an idea of how sustainable that yield is, while the Dividend Growth Rating can tell you if it’s likely to go up.