With dividend growth investing being a very popular method for creating a growing passive income stream for the long haul, many first time investors might feel intimidated by the process of actually building up and creating their own dividend investment portfolio. While I can understand the hesitation and resistance some might feel to wanting to undertake such an endeavor, I can say first hand that the task is not as difficult as some might want you to believe. Creating your own investment portfolio that can provide you an ever increasing dividend income stream need not be difficult if you stick to some basic guidelines and investing principles during all market conditions. These investing traits have carried me through some of the toughest times to hold equities and today I am glad I followed my own set of rules as it has served me well for many, many years. With that being said, let's dive into my personal method for selecting dividend paying stocks.
Back in 2007, when I decided to become a dedicated dividend growth investor, I chose to build the foundation of my portfolio upon the Dividend Aristocrats list. To me, this list entails the 'best of the best' in terms of finding excellent long term dividend growth stocks. To make the elite Dividend Aristocrats list, a stock must raise its dividend every year for at least twenty-five years. If a company can achieve this feat it's a clear sign that management has a shareholder-friendly dividend distribution policy as well as the ability to manage cash flow in order to continually raise its dividend year after year. Names that I have considered from this list and are included in my current portfolio are Archer-Daniels-Midland Company (NYSE:ADM) with 40 years of dividend raises under its belt, Emerson Electric Co. (NYSE:EMR) with an impressive 59 year history of raises and 3M Company (NYSE:MMM) with 57 years of consecutive growth, to name a few. Of course, this is not an endorsement of blindingly building a portfolio solely from stocks on this list; rather, it's a solid starting point for further research to pick and choose from some of the most solid and reliable names in their respective industries.
Next, I like to look at the payout ratio of a stock that I am considering. The payout ratio is simply a proportion of earnings that is paid out as dividends to shareholders. Typically, I like this ratio to be well below 80% as it would indicate a sustainable dividend yield with room for future growth based on current earnings. When payout ratios exceed 80%, it typically signifies a dividend that may not grow in a particular year or, worse, may be cut. After all, the purpose of being a dividend growth investor is to build a portfolio of annual dividend growers and not cutters so paying attention to earnings/cash flow and the payout ratios becomes crucial. Some names with low payout ratios in my portfolio include Illinois Tool Works Inc. (NYSE:ITW) at 39.8%, Becton, Dickinson and Company (NYSE:BDX) at 30.8% and CR Bard Inc. (NYSE:BCR) with a low 9.5% payout ratio, indicating a very safe dividend with room for future growth based on current cash flow.
Many first-time investors sometimes do not pay attention to payout ratios and instead focus on yield alone. This can be a mistake as high yields often indicate something inherently wrong with the company in general, as well as a potentially unsustainable dividend. For regular dividend-paying stocks I like to see yields well below 5%. Anything higher raises flags.
Continuing on my search for potential dividend stocks to add to my portfolio I look for stocks trading at decent to good values. Using the most simplistic measure, I pay attention to current, forward and historical P/E ratios. From Investopedia: "The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings." With this basic metric for judging value, I am able to see if a stock is trading at a good value or not. While not directly correlated to dividend health, the P/E ratio can help determine if the stock is offering a good current yield or not. Some current stocks from my portfolio that are trading at current low and historical PEs include, W.W. Grainger, Inc. (NYSE:GWW) and The Bank of Nova Scotia (NYSE:BNS), to name a couple.
Diversity among my dividend payers is crucial too. While scouring the Dividend Aristocrats list, it's important to find stocks that hail from various sectors and industries. Personally, I favor the consumer staples the most for my long-term portfolio as the sector offers many very defensive and stable long time dividend payers. I own stocks from other sectors as well, including industrial, finance, health, conglomerates and more. For personal reasons, I never owned any energy nor tech stocks in my long term dividend growth portfolio for the anxiety these volatile sectors potentially provide. The way I see it, asset allocation is merely a reflection of your own investment tastes and tolerance for risk. By most measures, my portfolio would be considered a lower risk and conservative collection of stocks.
There you have it -- my basic methodology for choosing dividend paying stocks. It's definitely part art and part science as sometimes certain investments just have a "right feel" to them even though the current numbers might not make perfect sense. If you have a long-term horizon and can find a growing and sustainable business, it might make sense investing in that company for the long haul. After all, a dollar or two difference here and there in share price usually does not make much difference in your long term returns, especially if your focus is primarily passive income growth. We all know that time in the market is much better than timing the market when it comes to compounding dividend returns.
Disclosure: Long ADM, GWW, BNS, ITW, BDX, BCR, MMM, EMR