You are right to seek dividend paying stocks. According to Ned Davis Research, from 1972 to 2006 dividend paying stocks returned 10% annually compared to only 4% for non-dividend paying stocks. Other studies show that from 1926 to 2006 almost half of the S&P 500's return was due to dividends paid by the companies.
Here is my checklist for picking a dividend stock.
- Simple Business: Companies that execute a simple business plan. They focus on their main core business, not growing into areas they don't understand. No conglomerates here.
- High Cash Balance: Our best prospect should carry at least next quarters dividend in cash. This isolates them from an unexpected downturn in the economy, or a new competitor.
- Low Debt Balances: Credit can be expensive or nonexistent in a credit crunch (like now). Also if a company is highly leveraged, when their interest rates increase cash flow suffers. This may put pressure on dividends.
- Positive Cash Flow: Duh. If they are not turning consistent profits, the dividend is not sustainable.
- Recession Proof Demand: Stick with companies whose products are not sensitive to economic changes. Consumers have to eat, they don't have to buy cars.
- Reasonable Pay-out Ratio: We don't want a company that is bleeding all cash flow off in dividends. That doesn't let them build cash for expansion or to weather tough times. It also places them close to having to borrow money if they have a tough quarter. Look for a pay-out ration of less than 75%.
Not every great company may fit all of these criteria, but keep them in mind when researching prospective companies to own.
These rules don't strictly apply to Real Estate Investment Trusts (REIT) or Master Limited Partnerships (NYSE:MLP). They have to pay out high dividends to maintain their tax status. This can be good, but it can bite in a downturn like now.
REIT's have no money put aside from their high rent, high occupancy past, now rents are renewing at lower rates and occupancy is suffering. They are finding it difficult to renew debt.
Disclosure: No Positions