Choosing Dividend Stocks: Six Steps For Finding These Safe, High-Yield Investments
by Louis Basenese, Small Cap and Special Situations Expert
Friday, January 22, 2010: Issue #1181
The latest tally from famed professor, Jeremy Siegel – author of the investing classic, Stocks for the Long Run - proves that dividend stocks are still the best investment. Period.
Yet everyone still loves to dog them for being boring and slow growers.
Big mistake.
Let me prove to you just how profitable dividend stocks can be – and then show you how to find the safest, highest-yielding investments in this market.
How a 3.7% Gain Means An Extra $370,000
In his study, Professor Siegel sorted the S&P 500 stocks by dividend yield, dating back to 1957, and recorded the return of the top 100 dividend-yielders versus the bottom 100 for each year.
The result?
Investing in the top yielders delivered an annualized average return of 12.5%, compared to an average return of 8.8% for the lowest yielders.
Now, a 3.7% difference might not seem like much. But if you started with a $1,000 portfolio and reinvested all the dividends, it would be worth $450,000 today. That compares to only $80,000 without the extra 3.7% pop.
So if you’re serious about making money – and I suspect you are – dividend-paying stocks are essential to your portfolio.
But how do we go about finding safe, dividend-paying stocks in this market?
After all, companies keep slashing dividends by a record amount. From 2007 to 2009, total dividend payments slumped by $72 billion – the worst decline in over 50 years.
Six Steps to Finding the Best Dividend-Yielding Stocks
When looking for the best high-yield dividend stocks, the simple answer might sound a bit backwards: Don’t chase yield.
This is because a high yield typically indicates that there’s a higher risk of the dividend being cut or – even worse – being eliminated altogether.
Instead, focus on companies with the following six characteristics:
- Simple Business: The fewer moving parts, the fewer things that can go wrong, thus sapping cash intended for dividend payments. So focus on companies with businesses that you understand, rather than massive corporations that have dozens of (often puzzling) operating segments. That means shunning companies like General Electric (NYSE: GE) and its countless divisions, and instead going for companies like Philip Morris (NYSE: PM), which only does one thing and kicks back a $2.32 per share annual dividend (a 4.6% yield).
- Steady Demand: After identifying companies with simple business models, the next step is to verify that there is demand for the product(s). After all, a company needs a steady stream of cash, so it can afford to pay dividends to shareholders. Stick to industries or sectors with recession-proof or recession-resistant demand (food, alcohol, tobacco, healthcare, etc.)
- Cash Flow Positive: If a company isn’t generating cash each quarter, the only way to pay a dividend is by borrowing or tapping into cash reserves. Such practices aren’t sustainable over the long-term – and the dividend will eventually be cut.
- High Cash Balance: Speaking of cash… it’s still king. Especially when it comes to maintaining a dividend. Consider it insurance against any unexpected slowdowns. At a minimum, insist on enough cash to cover one quarter’s worth of dividends.
- Minimal Need for Credit: Securing credit in this market is extremely difficult. Accordingly, I recommend focusing on companies that don’t need to raise significant amounts of capital. That’s because when interest rates rise, so will their interest payments. I also suggest you look at companies with a reasonable, or low debt load. This ensures that interest payments won’t sap money intended for us.
- Earnings Buffer: Insist on a dividend payout ratio (annual dividends divided by annual net income) of 80% or less. This will provide ample wiggle room for the company to pay the dividend in the event of an unexpected slowdown. Or even better, to justify raising the dividend.
Three Profitable Dividend Stocks to Buy Now
After enjoying a hearty rebound in 2009, don’t be surprised if dividend investing starts attracting the herd in 2010. Many didn’t fully participate in the rally and now are undervalued, so they represent a safe way to invest in stocks.
Add in the fact that Treasuries still sport record-low yields and corporate bonds have already enjoyed a historic rally… and dividend stocks become even more attractive.
So I recommend that you front-run other investors. And the time to do that is now.
I’ve covered several suitable and safe dividend stocks in previous Investment U columns. In addition to Philip Morris that I mentioned a moment ago, you should also consider…
- Windstream Corp. (Nasdaq: WIN), which sports a $1 per share annual dividend (9.2% yield).
- Lorillard (NYSE: LO), which pays a hearty $4 per share annually (5.2% yield).
All three stocks remain attractive at current prices.
Good (and safe) investing,
Louis Basenese
Any investment contains risk. Please see our disclaimer.
9 Responses to “Choosing Dividend Stocks: Six Steps For Finding These Safe, High-Yield Investments”
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In addition to being the foremost expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
Louis,
A quick question about dividend stocks, should you re-invest the dividends or allow dividend to increase cash balance?
Thanks.
Reply
Tom,
That really depends on what your personal situation and what you’re looking to get out of your investing experience. We suggest that you consult a financial advisor about which is best for you.
Good investing,
Investment U
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Mr. Basenese:
In your January 22 Investment U article you refer to a stock you recommended in the latest issue of the Oxford Club Communique. The January, 2010 issue is the latest on the web page. In that communique you dealt with small-cap stocks, and I cannot find reference to the undervalued company with history of increasing dividends. Are you possibly referring to a recommendation in the forthcoming February communique which has not yet made it to the web page?
Thank you.
Don Barnhorst
Reply
Like the article says: beware of very high dividend yields. There are plenty of stocks available that still pay a respectable dividend.
Check out the top 250 here:
http://www.TopYields.nl/Top-250-dividend-yields.php
Reply
I believe I am a member of Oxford Club. If so, why continue to send me wasteful teasers?
If I’m not a member, please advise.
Reply
Joe,
We must apologize for these types of “wasteful teasers” that we continually send to our subscribers, but these types of advertisements help to keep Investment U free. If you wish to stop receiving these promotions you can unsubscribe from those adverts or you can follow IU through our RSS feed on your feed-reader.
Thank you,
Investment U
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If we find dividends paying stocks that come right back to market value after the ex-date (WIN) why wouldn’t you just bounce from stock to stock using the multiple dividends each month, lets say 3, and starting with $10k. The dividends more then pay for the transaction costs and with some of the higher yielding companies this could really add up.
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I might have missed the reply to this ?– please let me know any replys to the ? about buying and selling dividend stocks after ex-dividend date and repeating the same thing over and over to make a nice income–
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This is a great article all dividend investors should read. You should also inspect the dividend payout ratio of most companies, and anything in excess of 80% signals trouble ahead & potential dividend cuts.
Also have a read at 5 tricks to successful dividend investing at http://www.high-yield-dividend-stocks.com/successful-dividend-investing.html
These are not really tricks but essential must-dos for any income investor. For example, a sample trick from the article that I like the most is:
Don’t Chase High Yield Dividend Stocks without Understanding the Business
Value investor Warren Buffet never buys a stock; he buys companies & businesses that he understands and thinks will be valuable businesses over the long term.
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