John D. Rockefeller once noted: “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
It certainly helped that his company, Standard Oil, had gained a monopoly over the oil business by the 1880s. At the company’s zenith, it would control over 90% of the refined oil market.
But of course, for most investors, investing in dividend stocks is much tougher. In fact, with the rise in interest rates during the past year — with the rock-solid 10-year Treasury at 2.8% — the relative yields are getting more competitive. And yes, it looks like the Federal Reserve will continue to increase rates, so as to make sure the economy does not overheat.
Now this does not mean you should avoid dividends. The fact is that they can be a nice source of ongoing income and help to build your wealth.
But then again, you need to do your homework — and also be careful with some of the potential downsides.
So let’s take a look:
Dividend Stocks Tip No. 1 — Don’t Get Fooled By a High Yield on a Bad Stock
With free online tools, it is easy to create a screen that provides you list of stocks with juicy dividends. But this can lead to big-time problems for your portfolio.
There is often a good reason for the high yield — that is, investors believe it won’t last! The company may simply not have enough earnings to justify the payout.
A prime example of this is General Electric Company (NYSE:GE). Let’s face it, the company has had considerable problems over the past few years because of mis-timed acquisitions and lagging cash flows. As a result, the company wound up slashing its dividend by half in mid-November. Oh, and this also led to a further 20% plunge in GE stock.
So when picking dividend stocks, a good approach is to consider the payout ratio. This is the amount of the annual dividend divided by the net earnings. So if the ratio is 60% or less, then there should be enough cushion for any issues and the dividend is likely not to be not cut.
Next, you need to see if the earnings are rising over time. And yes, be cautious of any potential threats of disruption to the business. Just consider what has happened to once dominant companies like Sears Holdings Corp (NASDAQ:SHLD) and Kodak that did not effectively deal with the wrenching changes in their industries.
Dividend Stocks Tip No. 2 — See If the Dividend is Growing
As the old saying goes: “Past performance is no guarantee of future performance.” But when it comses to dividend stocks to buy, past performance is still a pretty good indicator.
If a company has a long history of consistently increasing its dividend, then this is a sign that the management is strong and that there is a solid product line which has been able to weather economic downturns. It’s also a good bet that the company enjoys powerful barriers to entry.
In light of this, some investors focus on the so-called Dividend Aristocrats, which are companies that have increased dividends for 25 consecutive years. As should be no surprise, the list is mostly composed of well-known blue chips like Exxon Mobil Corporation (NYSE:XOM), The Coca-Cola Co (NYSE:KO) and Johnson & Johnson (NYSE:JNJ).
Yet I think this approach is too restrictive. It means that you will probably miss out on picking standout companies.
So I instead prefer a 10-year rule. This is enough time to demonstrate that a company’s dividend history is not mostly the result of temporary positive trends.
Dividend Stocks Tip No. 3 — Understand the Tax Issues
From a tax standpoint, there are advantages to dividends. If they are considered “qualified,” then the cash payment is treated the same as if it were a capital gain. This means that the maximum rate is 20%.
However, if the dividend is “ordinary,” then the payout will be subject to the same rates that apply to your wages — which means a maximum of 37%.
In other words, make sure you understand the nature of the dividends. Keep in mind that ordinary dividends are often paid on REITs (Real Estate Investment Trusts), MLPs (Master Limited Partnerships) and tax-exempt companies.
Although, if you want to shelter this income, you can set up an IRA or some other type of tax-advantaged vehicle.
Finally, some companies allow you to reinvest your dividends back into more shares. While this can be a good approach, you need to understand the tax consequences. The bottom line: You still are required to pay taxes on the dividends.
Tom Taulli is the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.