If you’re a retiree or income investor, then having a great dividend strategy is absolutely essential. Dividends are a great source of passive income, but not all dividend stocks are created equal. Avoiding key pitfalls can protect your portfolio from disaster, and making some really smart decisions along the way can drastically improve your results over the long term.
As you sit down to allocate your stock portfolio, consider these three investing tips to set yourself apart from the crowd.
1. Don’t assume that larger yields are always better
It’s easy to get excited by a stock with a higher dividend yield than all of its peers, but it’s usually a mirage. There’s a reason the market has allowed the yield to creep so high — investors are likely expecting the dividend to decline.
A company may have entered a difficult period and forecasted cash flows won’t be enough to sustain previous payout levels. Perhaps the company declared a special one-time dividend that it’s not scheduled to repeat.
To address these issues, be sure to look at the forward dividend yield rather than just the trailing figure. That should account for dividends that have already been slashed or halted. You can use the dividend payout ratio to confirm that distributions to shareholders can be funded by operating profits.
To determine if the company’s payout ratio is sustainable, you can also look at guidance and forward-looking statements provided by the management team. These statements in financial filings, press releases, and quarterly conference calls hold important insight regarding the business moving forward.
Consensus analyst earnings estimates also provide clues on upcoming cash flows. More often than not, high dividend yields are accompanied by high payout ratios and uncertain earnings outlooks. Look out for these land mines.
2. Prioritize stability
Stability is one of the most important features of dividend stocks. High-growth companies typically don’t return capital to shareholders. Instead, they use the cash at their disposal to acquire new customers and fuel sales growth. Conversely, large and mature companies usually have slower growth rates and more predictable results. These companies create value for shareholders by regularly distributing profits in the form of dividends.
That’s exactly why stability is one of the most important considerations for dividend investors. You’ll want to make sure that your portfolio is comprised of high-quality stocks with sustainable profit margins, healthy balance sheets, and competitive advantages.
You should embrace stocks with economic moats, which prevent competitors from stealing market share. Moats can include high switching costs, long product replacement cycles, a network effect, intellectual property, technical leads, or exceptionally strong brands. These all protect a stock’s profits from eroding over time. Many Dividend Aristocrats have wide moats, which are a major factor that’s allowed them to increase their dividends every single year for decades.
Dividend investors should also pay special attention to financial health and cash flow efficiency. Companies that carry large amounts of debt might struggle to make scheduled payments during difficult economic times when cash flows dry up. You can use metrics like a coverage ratio or quick ratio to assess the risk associated with excessive debt. The cash-to-income ratio is also important for measuring how much of a company’s accounting profits are being converted to cash inflows.
3. Don’t forget about growth
Remember that the best dividend stocks provide some growth, even if it doesn’t match those tech rockstars with soaring valuations. Assets that appreciate are obviously valuable to any investor, but growth plays an especially important role for dividend investors. Inflation slowly eats away at the buying power of a dollar, so dividends must be higher in the future to have the same real value as dividends today.
Equity holdings are an important piece of retirement portfolios, because stock prices generally rise with inflation. Retirees who only hold cash and bonds are at risk, especially if they’re going to live off those savings for decades after they stop working. That’s one of the reasons Dividend Aristocrats are judged by consistently increasing their payouts, rather than simply sustaining their distributions.
It’s important for dividend investors to consider stocks that aren’t completely stagnant. Leaders of industries that are matching or outpacing wider economic growth rates can be great income stocks. Companies that shrewdly expand into adjacent markets are also attractive opportunities.
Consider a stock like PepsiCo, which has benefited from growing its geographical footprint and expansion into more food products. The stock has delivered consistent dividends, and its price has also increased more than 120% over the past decade. That’s exactly the sort of balance that can make a difference between a mediocre and excellent dividend stock holding.
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.