Look over these valuable guidelines before you invest in anything else.
Although dividend stocks do not seem to be as attractive as high-growth stocks, acquiring and holding them can produce high returns for investors who have the patience to wait. However, with the market staying at unprecedented peaks and interest rates poised to increase, investors need to be extremely discriminating when it comes to dividend stocks. The following eight useful tips will guide you into the most efficient strategies for your portfolio.
1. High yields are not enough. High yields are fine; however, focusing on them can lead you to miss the issues that might undermine or suspend the dividend. Likewise, you could lose your way around strange sectors and strange companies, bringing us to the next related tip.
2. Avoid sectors unfamiliar to you. Last year, an investor bought stocks of the shipping container company Textainer because he was attracted to the company's high dividend yield (more than 6% then) and low valuations dividend yield; however, he did not realize that the seasonal shipping container industry experienced an extreme dip as a result of the glut of containers worldwide, inexpensive steel and China’s economic decline. Textainer suffered from those factors and had to reduce its dividend twice, leading to the stock’s drop.
3. Evaluate the payout ratios from the start. Look beyond a stock's projected yield and take the dividend as a percentage of the company's earnings and free cash flow to find out if its payouts can be sustained. For instance, Casino giant Las Vegas Sands paid 137% of its earnings and 126% of its free cash flow on dividends for the last year -- suggesting a reduction of their 5.1% yield in the coming months ahead.
4. Measure valuations according to comparable peers in the industry. The recent years saw many dividend stocks catching up as a result of a low-interest rate condition, making bond yields not so appealing. However, as interest rates and bond yields increase, many investors will begin selling their income stocks -- especially those that have much higher valuations – in favor of bonds. Tobacco big-player Altria was a popular and secure market choice; yet it now trades at a level of 26 times its earnings, a level way above the average of 21 in the industry.
5. Aim for stable earnings and growing free cash flow. When a firm regularly has both figures on the rise, it can give out dividends consistently. However, if the two sink to the bottom, expect a cut in dividends. As a prime case, Las Vegas Sands gave out $2.9 billion in dividends in the past year. Checking out its unstable net income and FCF growth in the last three years, however, shows how undependable its dividend really is:
6. Evaluate its track record of dividend increases. Firms that aggressively promote their stocks as income investments tend to raise their dividends yearly. Those that have done this for more than 25 years enter the list of elite "dividend aristocrats", such as AT&T, which has increased its dividend yearly for more than 30 years. Companies such as these tend not to cut or stop paying dividends in spite of a severe financial meltdown worldwide.
7. Get a DRIP (dividend reinvestment plan) to reinvest your dividends. If you can afford to reinvest dividend income immediately, enroll our stocks in a DRIP, allowing you to automatically acquire additional shares of the stock while getting a little price discount in the market. You will benefit from: savings in commission charges, averaged purchase price over time and automatic increase of your position due to the compounding effect.
8. Consider your effective yield. As a stock’s price rises and its yield dips, investors usually sell the stock to acquire one with more returns. In that case, the investor has not considered his or her "effective" yield, which is the percentage the stock effectively yields based on the price of the principal.
For instance, AT&T presently has a forward yield of 4.8%. But an average AT&T purchase price of $33.74 will grant an "effective" forward yield of 5.8%. Hence, one will hesitate to trade his AT&T shares for another stock with a 6% yield.
The key takeaway
There are no foolproof steps for selecting the winning dividend stocks. However, putting your trust on those stocks you are familiar with, monitoring their valuations and payout ratios instead of yields, and putting back your dividends into the investment will go a long way toward gradually building wealth for you though the going gets rough.