There are four key attributes that need to be considered in order to be successful at dividend investing: quality, earnings growth, entry price and sustainable distributions.
While investors could argue that one cannot put success in a pre-packaged recipe for achieving success, my four ingredients below are essential for my income investing strategy.
I believe in purchasing quality dividend paying companies, which means that I try to focus on companies with strong competitive advantages, strong brand names and/or wide moats. Companies like that offer a product or service which customers desire, and are willing to pay a price which would deliver a fair profit.
In addition, companies which offer products which are perceived to have quality characteristics, which typically translates into repeated purchases of the goods or services.
In addition, companies that offer a unique product or service are able to compete based upon the added value they bring to the marketplace, and avoid costly price wars with competitors.
Furthermore, the company would be able to have pricing power and pass on costs to customers, which will be much less likely to switch to another product. I understand that quality lies in the eyes of the beholder, but through experience, dividend investors should be able to uncover quality dividend paying gems.
My strategy focuses on purchasing shares in companies that will grow dividends over time. In order to achieve that however in a sustainable manner, companies need to be able to grow earnings. Businesses that manage to grow earnings also tend to become more valuable over time.
I also prefer to focus on earnings per share rather than total net income. Companies can grow earnings either by expanding in new markets, introducing new products, marketing existing products to new customers, acquiring competitors, cutting costs or raising prices. I like to read about companies which have specific earnings growth targets. Coca-Cola (KO) is an example that immediately comes to mind when I think about specific growth plans. I also like to see companies riding a long-term economic trend.
Many of the companies I own will benefit from the increase in number of middle class customers in emerging markets such as China and India. Others like Eaton Vance (EV) or Ameriprise Financial (AMP) will benefit from the increased need for financial products that generate income in retirement by the millions of baby boomers that are expected to retire over the next two decades.
The price at which shares are acquired matters a great deal to investors. Even if an investor has identified the best dividend growth stock in the world, with the widest moat, and excellent prospects for earnings and dividend growth, they could still end up losing money for extended periods of time.
The reason is that even the best dividend stocks are not worth owning at any price. If you overpay for your stocks, you might end up with losses or not gains to show for your efforts for extended periods of time, even if the underlying fundamentals improve according to your initial plan.
Companies such as Coca-Cola and Walmart (WMT) were grossly overvalued in 2000s, which is the primary reason why the stocks didn’t generate much in total returns over the next decade, despite the fact that earnings and dividend increased substantially during the period.
I am not proposing that investors time the market and only invest when stocks are super cheap. Instead, I focus on screening the dividend growth lists for attractively valued companies on a regular basis, and then analyze in detail the companies that are spitted out by my screen before adding money to them.
The next key ingredient for successful dividend investing involves the sustainability of distributions. Investors who purchase dividend stocks for income should check whether the company is able to adequately support distributions from current earnings or cash flows for certain entities such as master limited partnerships or real estate investment trusts.
For most corporations, a dividend payout ratio below 60% is generally preferred. A higher ratio could jeopardize the dividend payment even if earnings dip temporarily. That being said, even if a company has a sustainable payout at the time of purchase, over time it could become unsustainable if it grow distributions faster than earnings or earnings decrease due to tectonic shifts in the business model.
The best situation I like to observe is when earnings and dividends grow at similar rates. For new dividend payers I typically observe situations where dividend growth is higher than earnings growth up to a certain payout ratio, after which it closely trails growth in profitability.
Full Disclosure: I have a position in all companies listed above.