This is a guest post from Mike, MBA and author of The Dividend Guy Blog where he writes about dividend investing. He is also the author of the book Dividend Growth: Freedom Through Passive Income US Edition.
In my previous guest post, I wrote about the reasons why successful investors choose dividend investing as their core strategy. Unfortunately, picking just any dividend stocks is not enough to guarantee that you will make money on the stock market. In order to avoid the dividend traps, it’s important to have a sound investing strategy. Here’s how you can do it in 4 easy steps.
Step #1: Screen The Right Stocks With The Right Metrics
A good dividend stock in your portfolio is one that you will keep for several years. You must be careful to not to fall for a high dividend yield stock or buy a company with inconsistent sales.
The power of dividend growth investing resides in companies that double their dividend at least every 10 years. This is how you can retire with a dividend portfolio yielding over 10%. In order to find this lucky lady, you can start your research by filtering the stock market with the following ratios:
- Dividend Yield >3% (I’m going after yield after all)
- 5 Year Dividend Growth >1% (I want this yield to grow over time)
- Dividend Payout Ratio < 75% (I want sustainable dividend growth)
- 5 Year Annual Income Growth >1% (I want potential for more dividend growth)
- ROE > 10% (I want companies making great investment returns)
- P/E Ratio <20 (I don’t want to pay too much for the stock)
There is a great free stock screener called FIN VIZ Stock Screener. I use it personally for 3 reasons:
#1 You have the ability to add several filters;
#2 You can go back to your original search and modify 1 or more filters and see the new results;
#3 You can export your search into Excel and play with them as you want.
This is how you find stocks paying healthy and sustainable dividends. This won’t lead you to the flavor of the month but sound investments.
Step #2: Don’t Buy The Same Stocks Twice
After pulling out your search results, you will be tempted to pick from this list since they are all supposed to be solid dividend growth stocks. Think again, your research process has just begun! You can continue your investment journey by making a list of 20 potential stocks. Then, a good reading of financial statements is required. You must make sure that the metrics you are looking at in your screener are not showing due to exceptional events and the business is sustainable.
You can also accelerate your process by considering a good diversification among your stock selections. If you have selected 4 stocks operating in the same sector, you might not want to pick all of them. They might be great stocks individually but if their sector is affected by economic events, you will have 4 stocks dropping at the same time. This is why it’s important not to buy the same stock twice.
For example, if you are looking at consumer staple stocks, you will probably find stocks like Clorox (CLX), Colgate-Palmolive (CL), Kimberly-Clark (KMB), Procter & Gamble (PG) and Johnson & Johnson (JNJ). Each company is not exactly the same but they share several points in their business models and operations. If you look at the graph for the past five years, you will notice that they follow a similar pattern but some have performed a lot better than others (click image to enlarge):
This is why it is important to select the “best” stocks for each sector instead of buying the whole industry. Someone who had many banks and financial services stocks in 2008 probably cried a lot!
The US stock market has many great dividend stocks in several different sectors. For example, you won’t have a hard time finding what you are looking for within financials, techno, or consumers. While I just showed you how your portfolio could fluctuate in a short period of time if you have invested in the financial, the energy sector is no different. In fact, the reason why you don’t want to concentrate too much in a specific sector is that you can’t know for sure if it’s a good move or not. You think you are smarter than the average bear and that you can’t go wrong? Well that’s only true if you are already a multimillionaire trader and have made your money through stock trading. You’re not? Then you are not likely smarter than me or the average investor. Just stick with good sector diversification instead of gambling ;-).
Step #3: DRIP IT!
It’s not always easy to build a diversified stock portfolio when you start investing. Chances are that you don’t have a lot of money to invest and this will limit the number of stocks you can hold in your account. By diversifying your holdings, you will have small positions in several stocks. A great way to increase each holding is by using the stock Dividend Reinvestment Plan also called DRIP.
Each time that a dividend payout is made by a company, the investor has two options:
1) Receive the dividend payout in cash in his brokerage account
2) Buy new shares under the DRIP program with no transaction fees
Here’s how a DRIP can be setup:
Assume you own 400 shares of Clorox (CLX). The stock price is trading at $75 and the quarterly dividend paid is $0.64 per share. This means that upon the dividend date, you will receive $256 in dividends (400 * $0.64). The amount can be deposited in your brokerage account and you will have to wait until you have more money to buy another stock. Or, you can setup a DRIP. Upon the dividend date, your number of shares will increase by 3 or 3.41 if your DRIP broker allows fractional shares. If you can’t hold fractional shares, you total shares will jump to 403 and you will receive $31 in cash ($256 - $225 of share purchase).
The interesting part is that your dividend payout will increase each quarter since you buy more shares. Following the above mentioned example, you will receive $257.92 in dividend the following quarter instead of $256. This magic results in a dividend payout increase of 0.75%. After a year, now show 412 shares and receive $263.68 per quarter, a dividend payment increase of 3%. Imagine what happen if you DRIP a stock for 10-15 years. You just get a small preview of the power of compounding interest!
Step #4: Don’t Blindly Follow Your Lover
Don’t we say that love is blind? Well I know that it’s true if you fall in love with your stocks! I’m sure you have seen investors keeping a blind faith in companies that have lost money and pushed their stock value down the hill. They keep saying that the company will come back and that they can’t sell right now. Falling in love with your stocks is probably the best way to lose a lot of money.
Instead, I suggest you follow your stocks through their quarterly results. You will be in a better position to see if the company keeps the reasons why you have selected it in the first place. Don’t give your stocks “chances” to be better in the future. If the dividend payout ratio is too high (over 80%) or if the company announces a dividend cut, you should pull the trigger early and sell it.
Here’s a quick tip: You can run your ratio analysis four times a year (about a month after each quarter… so on February 28th, May 30th, August 30th, November 30th). Why wait so long after the financial quarter finishes? Because companies usually don’t disclose their results until 4-5 weeks AFTER the end of the quarter.
Time Will Become Your Best Friend
Dividend investing is for patient investors. It’s only over the long run that you will benefit from the compounding of dividend growth and that you will clearly see the power of dividend investing. It’s important to establish your own set of rules and follow them. Most of the time, a sound investing strategy is boring but it pays in the end!
Disclaimer: I hold shares of JNJ.