Friday, July 10, 2009
Editor’s Note: Today, Investment U’s Louis Basenese gives a rundown on the benefits of having dividend-yielding stocks in your portfolio - and provides six tips for ensuring that you pick the best ones. He also gives two dividend stocks that are good value today. This is the latest guest essay from our colleagues at Investment U, as we broaden our market coverage.
Martin Denholm, Managing Editor, Smart Profits Report
What Is The “Bond King” Recommending?
I just finished reading Bill Gross’ latest market commentary. It’s something I do every month. And I recommend you do the same.
Forget that it’s always entertaining, informative and often loaded with unconventional investment perspectives. Read it because the man controls a boatload of money.
At last check, his PIMCO Total Return Fund - the largest mutual fund in the world - boasted $159 billion under management.
With so much at stake, he can’t make investment recommendations flippantly. They require deep thought… and a track record of accuracy. Otherwise, investors wouldn’t keep entrusting him with their money.
Bill Gross is the “Bond King.” Or, as The New York Times likes to say, “The nation’s most prominent bond investor.”
So what’s he recommending now?
Bonds, of course. Not doing so would be sacrilegious… and detrimental to his business.
But Gross also likes “stable dividend-paying equities.”
The Benefits Of High-Yield Investments
Here’s my rub, though. Gross is ambiguous. A “stable” dividend-paying stock is not self-evident. And investing in unstable dividend-paying stocks can lead to disastrous results (i.e. - a stock that cuts or cancels its dividend AND drops in price).
So let me provide you with a six-step screening process to easily identify stable dividend-paying stocks.
Countless studies demonstrate that dividend-paying stocks outperform non-payers by a wide margin. For example…
- From 1972 to 2006 dividend-paying stocks returned an average of 10% annually, versus 4% for non-dividend payers, according to Ned Davis Research.
- Going back to 1926, other studies confirm almost half of the S&P 500’s return was due to the dividends paid by the companies in the index.
So I’ll take Bill Gross’ recommendation one step further. Forget now. Dividend-paying stocks always deserve a place in your portfolio.
Yet, in this market, it’s increasingly difficult to find reliable dividend stocks.
Weathering The Storm
In January, Howard Silverblatt, Senior Index Analyst at Standard & Poor’s, predicted that, “This is going to be the worst [dividend-cutting year] in 50 years.”
Keep in mind, Dow Chemical had maintained or increased its dividend every year since 1912. That means conditions this year are worse for the company - at least on a cash flow basis - than during the Great Depression.
Against this backdrop, it’s understandable why many investors consider no dividend safe. But that’s a mistake. Fact is, countless companies will weather this storm with their dividend intact.
And to find such companies, I focus on the following six criteria…
Six Ways To Pick A Dividend Stock
~ Steady Demand: Given the “Great Recession,” the first thing we need to verify is the demand for a company’s products. After all, a company needs a steady stream of cash to afford to pay it out to shareholders. Stick to industries or sectors with recession-proof (or recession-resistant) demand. That includes food, alcohol, tobacco, healthcare, etc).
~ Simple Business: The fewer moving parts there are, the less money gets sapped when things go wrong - cash intended for dividend payments. Focus on companies doing one or two things that you understand, rather than massive corporations with dozens of operating segments.
~ High Cash Balance: Cash is 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 focus on companies that don’t need to raise significant amounts of capital. Remember, too, when interest rates rise, so do interest payments for companies that rely on a significant amount of debt. So it’s also important to focus on companies with reasonable or low debt balances. This insures interest payments won’t sap money intended for us.
~ Cash Flow Positive: If a company isn’t generating cash each quarter, the only way to pay a dividend is by borrowing it, or tapping into cash reserves. Such practices aren’t sustainable over the long-term. Eventually, the dividend will be cut.
~ Earnings Buffer: Insist on a dividend payout ratio (annual dividends/annual net income) of 80% or less. A company paying out 100% of earnings has no wiggle room in the event of a slowdown. If business suffers, so will the dividend.
Obviously not every stable dividend-paying stock will meet all these criteria. But the more criteria a stock fits, the more stable you can consider its dividend.
I followed these six criteria to unearth dividend stocks like TEPPCO Partners (NYSE: TPP), Lorillard (NYSE: LO) and Windstream Corp. (NYSE: WIN). Lorillard and Windstream remain attractive at current prices.
Have a good weekend,
Disclosure: No positions