Retired investors searching for a regular income stream that can supplement pension and social security benefits, part-time work, annuities, and investment withdrawals may want to consider creating a diversified portfolio of dividend growth stocks. Companies that have a history of steadily increasing payouts, that are growing earnings, that are reasonably valued, have low debt levels, and offer a relatively high current yield should be high on the list.
To find the best dividend stocks for retirees, I use the following criteria:
1) Valuation: reasonable valuation (TTM P/E that is lower than the overall market and in line with recent company history).
2) Growth: dividend stocks with dividend growth rates that are greater than inflation (and likely to continue at the same pace going forward).
3) Yield: Dividend yield greater than 125% on those of less risky investments (such as the 10-year Treasury note) is a must-have if you’re screening for the best dividend stocks in the market.
4) History: a long history of annual dividend increases (recommendation of 25 or more consecutive years).
5) Debt: long term debt/equity ratio less than 1.0. Great dividend stocks don’t need to leverage themselves to their eyeballs to reward investors.
6) Payout ratio: payout ratio less than 60%. Companies using less than 60% of their earnings to pay their dividends can pay them comfortably and reliably.
7) Intangible: factors such as diversification, positive industry outlook, and recent news also come into play.
Companies with a long history of boosting payouts to shareholders will probably continue to do so going forward, all other things being equal. For example, members of the S&P500 Dividend Aristocrats, considered some of the best dividend stocks on earth, have increased the dividend every year for at least 25 consecutive years. Some companies have boosted the payout annually for more than half a century. Unless something dramatic occurs these companies will likely continue to pay and increase dividends.
In addition, a retiree should expect that the increases stay ahead of inflation. Using data from the U.S. government, one measure of inflation, the Consumer Price Index , has increased 81% over the last 25 years, or at a compounded 2.4% per year.
Therefore, the stock should average an annual dividend growth rate of at least 2.5% over the previous five years, with higher values preferred.
The second factor that helps separate the best dividend stocks from the rest is valuation. Buying stocks that are reasonably priced will increase the likelihood of positive overall returns (dividend plus capital gains) over the long term, especially in this current environment of “frothy” valuations.
The TTM P/E of each stock will be compared to the overall market, the industry that the company competes in, and the previous half decade for each stock.
The S&P500 large-cap stock index has a trailing 12 months (TTM) price/earnings ratio, P/E, of nearly 21, well above its longtime mean of 15.5.
To get a jump on creating a meaningful initial income stream, and with the added goal of the payouts increasing over time, I recommend stocks that have a relatively high current yield that can’t be easily obtained elsewhere, say through bonds or money market accounts.
I picked the U.S. Treasury 10-year note as the baseline to compare to the dividend yield. The T-note currently has a yield of 1.87%. Therefore, stocks considered for the dividend portfolio should have a higher yield to account for the added risk of purchasing equities instead of bonds. I chose a minimum yield requirement of 2.5% after allowing for a 25% margin above the bond yield.
Companies that have stocks with relatively low payout ratios, the current dividend divided by the trailing 12-months earnings per share, have more flexibility to raise shareholder payments in the event of lower future earnings and without having to borrow.
Stocks with payout ratios of 60% and lower (but not too close to zero) will be considered for the dividend portfolio.
The last category is debt. Corporations that do not have a problem in servicing long-term debt can use excess cash flow instead to grow the dividend.
The criteria to be used for evaluating debt will be the debt-to-equity ratio. The portfolio should contain dividend stocks with a long-term debt/equity ratio less than 1.0 (and as close to zero as possible).
Using the numerical criteria above, and based upon financial data as of the end of 2015, five (5) stocks met most of the selection criteria and are candidates for the dividend portfolio:
1. Cincinnati Financial Corporation (CINF),
2. ExxonMobil (XOM),
3. Weyco Group, Inc. (WEYS) (met all but the dividend growth rate criteria),
4. Wal-Mart Stores (WMT)
5. Sonoco Products Co (SON)
Table I contains a summary of the numerical criteria for each company.
|Company||Ticker||Div Yield (%)||Div Growth Rate (%) Over 5 Years||Long Term Debt/Equity||Payout Ratio (%)||# Years Of Consecutive Increases||TTM P/E|
Dividend Stocks Numerical Criteria
(*) CINF just announced a dividend increase in January
The final selection process also needs to include some of the “other factors” I discussed above. I will use my own portfolio as an example. Since I already own shares of an energy company, Chevron (CVX), and considering diversification to be an important factor, I would be hesitant to add ExxonMobil, which is also in the same industry. Also, based upon the recent drop in the price of oil, which is dramatically affecting revenue and earnings in the industry, it is possible that these companies might hold back on future dividend increases.
Therefore, based upon all of the factors, the final selections would be Weyco Group, Wal-Mart, and Sonoco Products for investors with existing exposure to insurance and oil.
Retired investors seeking a reliable income stream should be looking for dividend growth stocks that are reasonably priced, have a long history of increases, low levels of debt, modest payout ratios, and competitive yields. Every investor’s situation is different, but right now Weyco Group, Wal-Mart, and Sonoco Products could fit that bill.
Disclaimer: The author owns shares of Wal-Mart, Chevron, Aflac, Chubb Corp.