4 Qualities of the Best Dividend Stocks

 |  Includes: O, SHW
by: David Van Knapp

A recent article on Seeking Alpha, "Looking for the Perfect Dividend Stock," laid out a useful matrix of categories such as "High Yield/Low Dividend Growth" and "Low Yield/High Dividend Growth," giving a couple examples of each type. One of the comments to the article noted, "There is no such thing as a 'perfect' anything stock."

While truly there is no such thing as a "perfect" dividend stock for all investors, I beieve there are four desirable characteristics in any dividend stock. What makes different stocks suitable for different dividend investors is how these characteristics are blended in each particular stock. By "dividend investors," I refer both to investors who are pursuing high long-term total returns by re-investing dividends as a principle tactic, as well as investors (such as retirees) who are drawing off dividends as current income.

The four most important characteristics are:

  • initial yield
  • consistency and safety of dividend payments
  • dividend growth
  • the potential for the stock to appreciate in price

Initial Yield: An ideal dividend stock ought to start off with a decent yield. That is, on the day you buy it, the stock should yield at least as much as, say, a bank deposit. Higher yield helps compensate for the risk of owning a stock, whose price is never guaranteed or insured.

That said, some leeway can be granted on the initial yield, because the best dividend stocks increase their dividends regularly. That distinguishes them from CDs and bonds, both of which are "fixed income" investments. So a stock whose initial yield falls a little short of a CD may catch and pass it in a year or two, because the company is increasing the dividend each year.

My personal requirement for the minimum initial yield from a dividend stock is 2.5%. I will go as low as 1.9% for "Dividend Aristocrats," a term used by Standard & Poor's for their list of stocks that have raised their dividends at least 25 consecutive years. At the end of 2007, the last time they compiled the list, there were 59 stocks that qualified. Not all of them yield at least 1.9%. Therefore, don't assume that a steadily growing dividend must be sufficiently high just because it is growing. The two are different factors that must be considered separately.

Consistency and Safety of Dividend Payments: The second characteristic is consistency (or reliability), not only in paying the dividend but in growing it too. There is no way to guarantee the future, of course, but we can draw reasonable inferences from past performance, current conditions, and intelligent projections. So, we want a company that displays:

  • Uninterrupted payment of a dividend for at least several years.
  • A sustainable payout ratio. (The "payout ratio" is the percentage of earnings that the company is directing to dividends rather than retaining for reinvestment in the company.)
  • A steady history of raising its dividend most (if not all) years.
  • No severe financial difficulties that seem to threaten the dividend.
  • An explicit statement from management that they are determined to pay and periodically increase the dividend. Or, lacking that, an implied intention based on the historical record plus current management statements that underscore the importance of the dividend.

My favorite company in the last regard is Realty Income Corp. (NYSE:O). It states its purpose as follows: "As The Monthly Dividend Company® our primary goal is to provide dependable monthly income to shareholders." As a dividend investor, you can hardly ask for a clearer statement of management's intentions in regard to the dividend.

Dividend Growth: The third quality of an ideal dividend stock is dividend growth. It is a company's ability to grow its dividend that separates it from "fixed income" investments like bank accounts and bonds.

As stated earlier, high current yield and steady dividend growth do not necessarily go together. Some companies increase their dividends infrequently or erratically. Other companies increase their dividends regularly, but they don't pay out very much of a dividend. So we must examine dividend growth separately from the size of the dividend.

My personal benchmark for minimum acceptable dividend growth is 5% per year (4% for Dividend Aristocrats). Ideally, I like to see a significantly higher growth rate.

Again, we look to the past to draw reasonable inferences about the future. My "go-to" statistic is the stock's annualized dividend growth rate over the past three years. It is not unusual to find rates of 15% or more. Often a stock's dividend growth rate closely tracks the company's earnings growth rate. I like that: It helps bolster my confidence that management will continue to direct a consistent percentage of earnings back to shareholders as dividends.

Yield and growth rate combine, of course, to determine the total dividend return to you. The math is simple. Say a stock is yielding 2.5% on the day you purchase it. If the company raises its dividend 15% per year, then in year two the yield on your initial investment will be 2.9%, in year three it will be 3.3%, and so on. Your personal yield will double in just under five years.

As an example, consider Sherwin-Williams (NYSE:SHW). Its current yield is 2.2%, less than my normal minimum. But it is on the Dividend Aristocrats list (more than 25 consecutive years of dividend increases), and it has grown its dividends 23% per year over the past three years (all data from Morningstar). While it may not sustain that growth rate (its 2008 increase was 11%), let's say we are confident in an annualized 15% growth rate for the foreseeable future. That means that the original 2.2% yield becomes 2.5% in year two, 2.9% in year three, and 3.3% in year four, all based on the original investment. Our original yield of 2.2% will double to 4.4% in about five years (based on the original investment).

Potential Price Appreciation: The first three factors focused on the dividend itself: its initial magnitude, reliability, and rate of growth. The fourth important factor in a great dividend stock is its potential to appreciate in price.

This is another advantage that dividend-paying stocks have over bank deposits and bonds. To use the phrase again, the latter are "fixed income" investments. Not only is their income fixed, but so is their principal. At the end of a bond's term, the principal is returned to you--ravaged by inflation. A stock, though, has a fighting chance to keep up with and exceed inflation. Historically, in fact, stocks have done just that.

Some investors believe that a dividend stock's price rises because of its dividend and increases to it. I don't go that far. I believe that any stock's price is determined by a host of factors, not all of them rational. Let's just say that the stock's dividend history is one factor that many investors consider in deciding a fair price to pay. The important fact is that the stock has the potential to grow in price, just as its dividend does. Depending on your personal goals, you may care a lot or just moderately about a dividend stock's price growth potential.

Everyone cares about the stock's potential to decline in price. To help guard against that, be sure to do your normal homework to determine an advantageous valuation for any stock you are considering. Try to buy at a price which provides a margin of safety compared to your calculation of the stock's fair or intrinsic value.

Disclosure: Long O and SHW.