Now that bank accounts are paying, well, nothing, more individuals are looking to the stock market to generate income. Today I thought I would discuss things that I look for when choosing dividend paying stocks.
While bank interest rates have fallen, many stocks have actually raised their dividends in the last several years in response to the Bush tax cut for dividends. Prior to 2003, dividends were taxed at ordinary income rates. Because they had been taxed previously at corporate tax rates before the investor received them, this resulted in tax rates approaching 50% before state taxes were even figured in. This made an incentive to invest in stocks that paid little or no dividend since capital gains were taxed a t a lower rate. Hence there was little incentive for stocks to pay large dividends.
After the decrease in taxes on dividends, companies began raising their dividends, and others started paying dividends for the first time. The desire to find stocks with dividends increased after the 2008 fall when investors started to want steady income since capital gains no longer seemed as assured. During the last ten years, the market, as measured by the levels of the major indexes, has remained about flat. Without dividends, a buy and hold investor would therefore had no return during the last decade. In such cases, even a small yield will matter.
In looking for stocks with dividends, the first thing I do, obviously, is look for stocks that have reasonably high dividends compared to the geenral market. A good way to find these stocks is to use Value Line Investment Survey. The Selection and Opinion section has a whole table of recommended high yielding stocks. There is also a table in the back of each issue with the stocks paying the highest dividends. Lacking this resource, one can also use the various screening programs provided by the different brokerage houses to find stocks paying good dividends.
The second thing I tend to do is pare the list down by taking out stocks whose dividend is too far above the average for the market. For example, if most stocks in a sector are paying 5% and there is one paying 12%, it seems very likely that the stock with the oversized yield may be having issues and may cut its dividend soon. A look at the recent price history will generally show this. For example if the price of the stock has dropped significantly recently, they may have announced that earnings are slowing and therefore while they have not cut their dividend yet, investors are expecting them to do so.
The third thing I do is look at the quality of the businesses and the stability of their sales. Companies that continue to pay dividends are those who have a large, mature business and steady customers. For example, utilities tend to pay large dividends and they have a steady income stream. It isn’t like everyone is going to stop using power on a whim. A large consumer company with a lot of products (like Procter and Gamble or Kraft) is also unlikely to see sales fall significantly since they sell a lot fo products people buy during good times and bad.
Fourth, I look for stocks with regularly increasing dividends. If a stock is paying 3% now, but is growing the dividend by 10% per year, in about seven years they will be paying the equivalent of 6% on the money that is invested now. (It is likely that the price of the stock will also increase along with the dividend, so they may actually still be paying only 3% in seven years for new investors, but if I buy in now my effective rate will be 6%.)
Finally, I look to see if I think the company is making enough income to afford to keep paying the dividend. If a company is making a net profit of $0.40 per share and paying a $0.20 dividend, they have plenty of cash to continue to pay the dividend. If they are only making $0.10 per share and paying a $0.20 dividend, there is obviously a large risk that they will cut the dividend. When that happens, the price of the stock will tend to fall and investors who have invested for the dividend move elsewhere.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.