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How to Pick Dividend Stocks

Theoretical purists will hate this, but I love dividend stocks. I know total returns are what really matter in the end, but I truly appreciate the discipline forced on executives managing a dividend paying company. As an added bonus, there are also psychological benefits to owning dividend paying stocks.

Executives at dividend paying companies don’t want to cut their dividend. Consequently, they work harder to preserve and grow cash flow. They also are more likely to return excess cash to shareholders instead of spending it on pet projects and empire-building. I believe dividends enforce a level of discipline on corporate executives.

I believe dividends enforce a level of discipline on corporate executives.

Moreover, a tangible, growing cash return provides a psychological buffer to the unpredictable ups-and-downs of the stock market. An investor that believes he will continuously receive his dividends will be less likely to make emotional sell decisions when things get difficult. Things are difficult right now.

During the Covid-19 coronavirus crisis, stock prices have plummeted. As stock prices plummet dividend yields have exploded. (Dividend yield = $ dividend per share / share price) This has attracted the interest of many investors that read this blog.

Just look at the sexy dividends in the table below (as at April 1, 2020). But beware – high dividend yields are sometimes like a siren’s call, attracting yield-chasers to their doom.

CompanyDividend Yield
IBM6.01%
3M4.42%
TD Bank5.83%
Altria Group8.95%

While on the surface a high dividend yield can look appealing, there is much more that needs to be considered.

Dividends are not guaranteed. They can be reduced or even eliminated. It has happened many times and will continue to happen in the future.

Broadly-speaking, Goldman Sachs is predicting the aggregate of dividends paid by companies in the S&P 500 will decline in 2020. According to US equity strategists at Goldman Sachs, S&P 500 dividends will decline by 25% in 2020 compared to 2019. Since dividends have already risen so far this year by 9%, that implies between now and the end of the year, dividends will decline by 38%.

The market collapse is barely a month old and we’re already witnessing numerous dividend cuts and suspensions. Here are just a few:

  1. Boeing: Dividend suspension
  2. Marriott International: Dividend suspension
  3. Ford: Dividend suspension
  4. Delta Airlines: Dividend suspension
  5. Freeport-McMoran: Dividend suspension
  6. Darden Restaurants: Dividend suspension
  7. Bloomin’ Brands: Dividend suspension
  8. BJ’s Restaurants: Dividend suspension
  9. Macy’s: Dividend suspension
  10. Nordstrom: Dividend suspension
  11. A&W: Dividend suspension
  12. Occidental Petroleum: Dividend cut
  13. Apache: Dividend cut
  14. Targa Resources: Dividend cut
  15. DCP Midstream LP: Distribution cut
  16. Sabre: Dividend suspension

At the same time, there are other companies that have (more-or-less) publicly stated they will not cut their dividend. CIBC’s CEO, Victor Dodig, on March 31st made the following statement on BNN:

“Our goal is to make sure that those dividends are flowing…I’d say one thing that’s incredibly important: Canadian investors that invest in our banks rely on those dividends for income. And every source of reliable income that we can provide to Canadians – and Americans, and our other shareholders that are investing in our banks – is incredibly important in this moment in time where cash flow reduces anxiety.”

So how are you supposed to know a dividend is secure?

You don’t.

Dividends – like price returns – must be viewed as uncertain. The likelihood of a future dividend exists on a scale of probabilities. Some are less likely to continue, others are more likely. Fortunately, there are ways to help identify dividends that are more likely to be paid in the future.

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Use history as your guide

Some companies have paid dividends for decades. In the US, “Dividend Kings” are companies that have consistently paid their dividends for over 50 years. Here’s a recent list of these companies.

Management at companies with a long history of paying dividends are more likely to do everything they can to protect the dividend. 1) No CEO wants to be the one to break a multi-decade track record. 2) After decades of protecting the dividend, shareholder cashflow management becomes part of the corporate culture and design. 3) A company that has consistently paid a dividend throughout previous crises is likely in an industry with relatively steady demand and predictable margins (compared to other industries).

Avoid dying industries

You could own shares of the best run company with a management team committed to paying a dividend, but if that company is in a deteriorating industry the dividend still might get cut. Remember record companies, newspapers and magazines?

You could own shares of the best run company with a management team committed to paying a dividend, but if that company is in a deteriorating industry the dividend still might get cut.

The challenge is that many companies in industries with a potentially big future (e.g. Tesla) don’t pay dividends. Companies in these industries might be growing fast, but they don’t yet have a stable source of cashflow. Instead, most dividend investors focus on are mature industries that will continue to stand the test of time – telecommunications, consumer non-discretionary, utilities, banks.

You’ll notice I didn’t include the energy industry. While this industry is mature and critical to the economy, it is highly cyclical and subject to the whims of the commodities markets. While there may be a place for energy companies within a dividend portfolio, I would consider these to be at the riskier end of the spectrum.

Find companies with cash to pay their dividends

When choosing dividend stocks, pick companies that can actually pay their dividends. This sounds like common sense, but when the high-yield sirens call many forget this.

Unlike many other items on financial statements, dividends aren’t some kind of accrued line-item. To pay a cash dividend a company must actually have cash. For a dividend to be sustainable, that cash must come from earnings. (Believe it or not, many companies finance their dividend payments by borrowing money.)

While I wouldn’t expect anyone to trace the origins of where a cash dividend came from, a simple measure can provide some guidance. The dividend payout ratio (annual dividend per share / annual earnings per share) indicates the proportion of earnings paid out as dividend. While companies in more stable industries can handle higher payout ratios, generally a payout ratio below 50% of earnings is very comforting to me.

Who is competing for your cash?

Stockholders get paid last. They receive the remnants of cash left over after interest payments on debt. Technically-speaking, debt is higher on the capital structure than equity. This means stockholders don’t get paid their dividends until after bondholders have received their coupons.

For this reason, when investing in a dividend paying stock you need to understand how debt affects a company’s cashflows. Conveniently, the dividend payout ratio somewhat bakes this into the calculation, since earnings per share shows what’s left after debtholders have been paid.

Still, it helps to understand how indebted the company is. This requires a bit of homework, but dividend investors should pay attention to a company’s debt-to-assets and interest coverage ratios. A heavily indebted company – especially one in a cyclical industry – will have a much harder time committing to dividend payments.

Yes, I have a life and day job

I don’t have hours a day to dive into company financials. The most prudent way to proceed is to assume at least some investments will at some point cut or suspend their dividends. (Mitigating unavoidable mistakes is part of the entire premise of DumbWealth.com.) My simple workaround is, within the equity portion of my portfolio, to diversify by spreading a portfolio across 20-30 dividend paying stocks and a range of industries.

This can be done by purchasing individual stocks or by buying an ETF that invests in dividend paying stocks.

Personally, for my long-term buy-and-hold investments I prefer to own the actual stocks. That way I avoid any perpetual fees associated with an ETF. However, this strategy would not make sense if my portfolio was small (say less than $20-30k) or if I had a shorter time horizon.

Please let me know below if you have any questions!

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