Investing in dividends is a slow and steady method of investing. As we all know, slow and steady wins the race. For example, Warren Buffett is known for investing in top-notch dividend-paying companies. This has helped him build his wealth over decades. He is also known for the following advice: “Always reinvest dividends!” Reinvesting dividends is a lucrative tactic in investing, especially since dividends will give you inflation protection, whereas most bonds will not.
So far, it might sound like a simple strategy: Find a company that pays dividends and reinvests those dividends over the years in order to build your net worth. However, it’s not that easy. You need to make sure you’re placing your bets on a quality name. Otherwise, you could see dividend cuts, dividend elimination, and stock price depreciation. Below are the factors you should be looking for.
Strong Cash, Low Earnings Expectations
The first thing you need to look for is consistent profits. If a company isn’t steadily profitable, scratch it off your list. It's possible to see healthy dividend returns from companies that are delivering profits but not profitable growth on an annual basis, but since dividend-paying companies showing profitable growth exist, there would be no sense in choosing the former. Tighten up your parameters and only consider companies delivering profitable growth.
Look for long-term earnings growth expectations between 5% and 15%. The reason you don’t want to go above 15% is due to the increased likelihood of earnings disappointments, which almost always nick the stock price.
While earnings drive profitable growth and are a key indicator of a quality dividend-paying company, cash flow is what pays for those dividends. That being the case, the next step is to make sure a company has strong cash flow generation.
Lastly, look for entities that have increased their dividend for five years or more. This greatly increases the odds of continued dividend growth, which is a big positive for investors. And make sure you buy shares prior to the ex-dividend date.
Don't Do Debt
Stay away from dividend-paying companies with excessive debt. In order to determine a company’s debt situation, look at its debt-to-equity ratio. If the debt-to-equity ratio is high, look elsewhere. Every investor is different in regards to what debt-to-equity ratio is too high, but consider excluding any company with a debt-to-equity ratio north of 2.00. Ideally, you want to see a debt-to-equity ratio below 1.00, which will allow you to sleep better at night.
If there is debt, then a company is more likely to at some point pay down that debt. When this happens, it means that extra cash is going toward deleveraging instead of to dividends.
Check Industry Health
This factor often goes overlooked, but it shouldn’t. At press time – April 2015 – major integrated oil and gas companies were suffering due to a plunge in the price of oil. The stocks have sold off, and due to weakening global demand and oversupply, stock price appreciation and dividend increases in the near future isn’t likely in most cases.
On the other hand, with baby boomers aging, the demand for healthcare services will be through the roof over the next two to three decades. This doesn’t mean healthcare stocks are immune to broader market plunges, but they’re likely to be more resilient than most stocks. And as long as the industry is in boom mode, there is more of a chance for dividend increases.
The point: Don't just pick a stock based on history. Things change. Take the soft drink industry, for example. With the rise of the health-conscious consumer, betting on sodas isn’t likely to be as much of a sure thing as in the past. The major players are moving into a healthier/alternative drink space, but it’s going to take time to establish themselves. There is no sense in taking a rough road when a smoother one is available.
The Bottom Line
If you’re going to invest in dividends, look for increasing earnings, long-term expected earnings growth between 5% and 15%, strong cash flow, a low debt-to-equity ratio, and industrial strength. When you find a stock (or stocks) that meet these parameters, consider setting up a dividend reinvestment plan.