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Every investor should be interested in dividends. This article describes how a dividend strategy fits into a total return portfolio with an emphasis on retirement needs. It is the third installment of my "Yield Quest" series. In Part 1 of this series I described the total return concept. In Part 2 I outlined the key allocation strategies.

My approach is a bit different from most authors emphasizing income investments. I believe that fear has created an over-emphasis on fixed income. This has pushed many investors into doing the wrong thing at the wrong time. I recommend that retirement investors should remain open to an approach emphasizing total returns. If the income stream is not enough, it is OK to sell some stock to meet current income needs -- as long as you have a portfolio that includes growth.

This installment, Part 3, analyzes one of the strategies, Dividend Investments. I urge new readers to go back to the first two installments to catch up.

Finding Strong Dividend Stocks

The focus on dividends is related to fear about stocks. Many investment advisors -- and much of the investment punditry -- have recommended dividend stocks as a way to hedge volatility. This captivating theme plays upon both the quest for yield from retirement investors and the general atmosphere of fear surrounding stocks.

The attraction of dividends is apparent in this chart (click to enlarge) from Google Trends, the result of a search for "dividend stocks."

Dividend stocks

The growing trend may not seem too dramatic, but, looking back to mid-year 2008, it shows a major increase in attention to dividend stocks. It demonstrates the general interest in yield.

Fair enough; yield is good. A company that has solid dividends, and dividend growth, is a company that displays confidence in the future and is willing to share current earnings returns with investors. This corporate philosophy is attractive to retirement investors as well as pension fund managers.

The Yield Trap (what not to do)

Investors emphasizing yield often make two mistakes.

  1. Screening for the very highest yields. I recently did this as an experiment. I set the screen for market cap and a few other factors. I excluded some pure yield stocks. The resulting list was quite interesting. It was a list of companies that would probably soon cut their dividends.
  2. Finding "pure" yield plays. This traps many unwary investors who choose yield stocks over bonds. Many stocks with good yields are bond proxies. Utility stocks are good examples. A utility without any strong growth characteristics is a plain vanilla yield play. It is just like a 100-year bond. If you believe that bond yields are bottoming -- and nearly everyone does -- you are avoiding buying the long-term bond. If you buy a stock that is a pure yield play, it is just like buying a long-term bond. If interest rates move higher, the stock price will move lower.

Let us illustrate this point with a simple chart (click to enlarge) -- very long-term -- of the Dow Jones Utility Index versus the ten-year note.

Bonds vs Utilities

While the inverse relationship is not perfect, you can readily see the general trend. Anyone buying utility stocks for yield must expect significant capital losses if rates spike.

Finding Good "Yield Stocks"

Here is the most important advice for finding a good "yield stock":

Find a good company that is attractively priced!

This recommendation may seem obvious, but it remains a mystery for many. I hear from many investors who start with the yield, which they see as a cushion for a possible decline in prices. This is backwards. You should start by finding a great stock. The yield is one -- but only one -- attractive feature.

Once you have found a stock that you want to own, which also has a good yield, it makes sense to analyze the dividend. The most important factors are the following:

  1. The payout ratio. Are corporate earnings sufficient to maintain the dividend?
  2. The dividend history. Has the company maintained -- or even better, increased -- dividends over time?

The result of this exploration may not be the stocks with the highest yield. Instead I look for very strong companies with sustainable yields.

Finding Ideas

The dividend concept is so popular that there are many sources of ideas. You can enter "dividend aristocrats" into your Seeking Alpha search or your Google search box and you will get hundreds of articles and thousands of suggestions. Some of those commenting on this series, (e.g.,David Van Knapp), are constantly searching for good candidates. There are many strong articles on dividend stocks, with many good ideas.

I always read comments with suggestions for suitable stocks or methods. I encourage readers to join the discussion.

My own key choices may emphasize the strength of the stock rather than the level of the yield. A good example is Caterpillar, Inc. (NYSE:CAT). The yield is only 2.2%, but the other metrics are all strong. If you like the company, the cost control, the diversification with earnings strength abroad, then you see the yield as competitive with bonds and plenty of additional upside.

Conclusion

When leading investment gurus say, "Why own a bond when you can own stocks?", they are often comparing the dividend yield of some stocks with the yield of the long-term bonds in the same company.

A wise investor, embarking on a quest for yield, should carefully compare the bond yield of top-rated companies with the dividend yield. In many cases owning the stock is a better choice.