The following is a guest blog post:
A diversified portfolio of dividend stocks is a great way to secure your financial future. That’s because as you might expect, a growing stream of investment income can pad your bottom line for years to come. And the best part is, for do-it-yourself investors it’s never been easier to get started.
But buying dividend stocks is not without risks, either. So in this article I want to share three tips that have helped me avoid dividend investing errors. Hopefully, by the time you’re done reading you’ll be even better prepared to protect and grow your portfolio of dividend payers for years (if not decades!) to come.
Tip #1: Consistent track records deserve a premium
When building a portfolio of dividend stocks, it pays to take a long-term focus. That’s because dividends that grow and compound over time can have a significant impact on your net worth. On the other hand, cyclical business without a strong dividend track record could leave you out in the cold.
That’s why I always like to focus on companies with a strong track record of dividend growth. And if not dividend growth, then I look for at last 5-10 years of consistent sales and earnings per share growth. Because it’s these kind of operating results that can power decades of dividend distribution.
After all, there’s a reason the dividend aristocrats still attract so much attention. While they certainly aren’t the hottest IPO on the street, they do have an impressive history of returning cash to shareholders. And that’s exactly what you want to see.
Tip #2: Dividend growth is better than current yield
One common trap that newer dividend investors tend to fall for is prioritizing current yield over dividend growth potential. But in my experience, this approach is a little shortsighted, especially since new investors likely have a long investment time horizon and would benefit more from the growth.
You see the problem with high current yields, is they often come with commensurate risks. That’s why any company that yields much over 4% is always a bit of a red flag for me. While I’m certainly tempted by the compelling quarterly payouts, I’m also aware they could be cut at any moment.
On the other hand, if you take a long term approach and focus on dividend growth potential, your retirement income down the road could be better off. Again, a commitment from company management to grow the dividend and return cash to shareholders, combined with a track record of steady growth in per share earnings can help turn you on to potential dividend growth opportunities.
And if you’re willing to patiently build your wealth for the long term, your eventual yield on cost can also be very compelling. Based on my experience, dividend growth stocks also have more upside capital gains potential as well, since management retains some cash to invest in growing the business (and dividend!)
Tip #3: Be aware of cash-adjusted payout ratio
While a strong track record of operating results and a commitment from management to grow the dividend is a good start, I encourage you to go a step further when evaluating a potential dividend stock investment.
In particular, I always like to look at the dividend in relation to free cash flow. The core thing to keep in mind here is the dividend paid out per share should be less than the free cash flow generated per share. Because over time, this is the only way the dividend distributions are sustainable. The specific thresholds to consider are up to you. But personally I get nervous if this cash-adjusted payout ratio starts to creep over 60%. Any higher and the dividend growth potential starts to come into question.
The reason I like to look at free cash flow rather than the standard payout ratio (which uses earnings as the denominator) is because net income can more easily be manipulated. Depending on how the company in question accounts for income, the earnings results may not be representative of the cash coming in the door each month. And since dividends require cash outlays on a consistent basis, I want a corresponding inflow of cash (not just accounting profits)!
Conclusion: The Tortoise Beats the Hare
I hope you find these tips helpful next time you’re screening for stocks. Because by taking a long term focus to building your dividend portfolio, you can really start to tip the odds of success in your favor. Because in my experience most dividend investing mistakes come when investors try to maximize current yield at the expense of future growth.
On the other hand, if you can be patient in your approach and regular invest in companies with dividend growth potential – as seen by a strong and long track record, a reasonable current yield and a healthy payout ratio – you’re much more likely to build a growing dividend cash flow machine that pays you well into your golden years. And what’s not to love about that?