Choosing Dividend Stocks: Six Steps For Finding These Safe, High-Yield Investments

by Louis Basenese Income Income

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

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