The Best Dividend Stocks: What To Look For?

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Includes: DVY, EMR, F, GE, GM, HDV, HRL, IDV, JNJ, KO, MCD, MMM, MO, NOBL, PG, SCHD, SDY, SPHD, SPY, VDIGX, VIG, VYM, VZ, WMT
by: From Growth to Value
Summary

This article is an expression of how I look at dividend stocks.

A lot of dividend kings underperform versus the market.

Dividend growth and payout ratio are underappreciated tools to pick outperformers.

A few dividend stocks can bring stability in a volatile market environment.

Introduction

My moniker is From Growth To Value. That has several implications. One of them is that I cover the whole spectrum: from growth stocks to value stocks. But it also means that I pick growth stocks that I think will become value stocks by holding them for very long periods.

Over the last year, I have been focusing more on growth stocks, for example, in my ongoing series Potential Multibaggers and Chinese Stocks To Buy Now. But this article is the first part of a new series in which I want to focus on DGI (dividend growth investing) again. For those who don't know, it is an investing philosophy in which you reinvest your dividends to buy more stocks with the dividends that you receive. Those dividends then generate more cash for even more dividend stock purchases, etc. DGI uses the power of compounding.

Some of my readers that love growth stocks might think dividend payers are boring and have low returns. And it is true that dividend stocks are often more mature and less volatile. But the combination of a growing dividend, a growing stock price, and holding your stocks for long periods can have great results. You can see that from this illustration:

(Source)

Also, dividends are often an important means for investors to prepare for the future. A lot of DGI investors use the strategy to prepare for retirement. They prepare to use the dividends and some of the gains to make a bigger retirement allowance.

What are value stocks?

What value stocks are exactly is not always so clear. There are lots of different definitions out there and therefore I would like to give you my own. For me, value stocks are stocks that pay a growing dividend, are valuated moderately (or even cheaply), and have great prospects, by which I mean that their businesses are not in some industry that I think will decline over the next few decades.

That means I stay away from a lot of traditional dividend stocks. I invest with an investing horizon of a few decades. And while I cheer for people that hold on to stocks they have owned for a long time, even if they perform somewhat less good now, I would not advise young investors with a long investing horizon to put money into some of the old economy's household names - the most typical DGI stocks there are.

So no Coca-Cola (KO) for me, no Walmart (WMT) or Verizon (VZ). The reason is that that their sales growth is pedestrian at best. Verizon: 1.7% over the past five years; Walmart: 1.30%; and Coca Cola: (-5.90%). They are able to squeeze out growth from reducing costs, but a slow or negative sales growth doesn't bode well for the future, as IBM (NYSE:IBM) has been showing for quite a few years now.

Maybe you shake your head now because you are not convinced and think that these three names are the best there are on the market now, but this is the list of the biggest companies in 1994 - 25 years ago:

(Source)

Some of these, especially from the biggest, have done very bad: General Electric (GE), Ford (F) and General Motors (GM).

Not convinced yet? This is the total return of ten dividend kings over the last 25 years compared to the S&P 500. I have picked ten names that are generally seen as high quality and that are household names for DGI investors: Johnson & Johnson (JNJ), Coca-Cola, Verizon, McDonald's (MCD), Procter & Gamble (PG), 3M (MMM), Altria (MO), Emerson (EMR), Walmart and Hormel Foods (HRL). Most DGI investors would consider this as a high-quality portfolio. But, as you can see, they all underperform the S&P 500 over that 25-year period:

Chart SPY Total Return Price data by YCharts

Now I know that this excludes the dividend reinvestment that DGI adds for the compounding of wealth. And I am confident that some of the stocks would outperform the S&P then, but I am also pretty sure most would still underperform if you would compare the S&P 500 total return with reinvested dividends.

I don't mean to disrespect DGI investors. Heck, I consider myself one of them! But with this article and the series that will follow, I want DGI investors to be aware that they can improve their results by not just picking the usual suspects, but looking at other options too.

Which dividend stocks to choose then?

The dividend stocks I choose are stocks of companies that have a higher dividend growth rate than most more typical names combined with a relatively low payout ratio.

A low payout ratio is essential. If you divide the market into five quintiles of highest to lowest dividends, the first quintile (with the highest dividend) has an average of 71% payout ratio, while the second quintile only has an average payout ratio of 41%:

(Source)

The results of the second quintile are much better than that of the first:

(Source)

The dividend raisers and initiators outperform all other stock categories, with less volatility:

(Source)

The fact that there is less volatility for dividend growers and initiators may be a good reason to have some in your portfolio. They might balance out the high volatility of some of the growth stocks that you might have.

While the outperformance in percentages may seem futile, in money, the difference looks much more substantial over the long term:

(Source)

As you can see, $100 grows to $8,267 for dividend growers and initiators, only to $3,055 for the S&P 500, and only to $327 for dividend non-payers. The dividend cutters and eliminators make you lose money even after such a long time of 45 years.

The growth comes from the growth

This is probably my most unclear (or philosophical?) header so far in my writing career here on Seeking Alpha, but what I mean is that the growth of dividend stocks mostly comes from the dividend growth of that stock. You can see that in this graph:

(Source)

Now, of course, that graph is worldwide, which is not the same as the US market, but it also holds for American stocks:

(Source)

So here again the numbers show that it is essential that a company has to be able to grow its dividend substantially. A 1% raise to keep up the streak of dividend growth will not be a substantial benefit for investors. I always strive for at least double-digit growth for years to come.

Dividend stocks: especially now!

While growth stocks have been very fashionable over the last years, outperforming most dividend stocks, you see that dividend stocks have gone out of fashion for individual investors, while institutional investors have bought more of them.

(Source)

The recent market volatility may be an excellent reason and time to add a few dividend stocks to your portfolio. A dividend stock can soften the high volatility we have been seeing over the last few months. For a lot of investors, it makes the waiting for price appreciation much easier because they feel they are paid to wait.

Conclusion

This article is a sort of touchstone for dividend investing the way I see it. Investors should look at more than just the yield or the streak that dividend kings have: payout ratio and especially dividend growth are much more important to outperform. Since more and more institutions are buying dividend stocks, this might be an indicator that dividend stocks are set to outperform again over the course of the next few years.

In the articles that follow, I will provide the reader with an analysis of what I see as some of the best dividend stocks to hold for the long term.

In the meantime: keep growing!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.