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One of the first things most new investors learn is that dividend stocks are a wise option. Generally thought of as a safer option than growth stocks, or other stocks that don't pay a dividend, dividend stocks occupy a few spots in even the most novice investors' portfolios. Yet, dividend stocks aren't all the sleepy, safe options we've been led to believe. Like all investments, dividend stocks come in all shapes and colors, and it is important to not paint them with a broad brush.

Here are the three biggest misconceptions of dividend stocks; understanding them should help you choose better dividend stocks. 

High Yield is King

The biggest misconception of dividend stocks is that a high yield is always a good thing. Many dividend investors simply choose a collection of the highest dividend paying stock and hope for the best. For a number of reasons, this is not always a good idea. 

Remember, a dividend is a percentage of a businesses profits that it is paying to its owners (shareholders) in the form of cash. Any money that is paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of its profits, it may be a sign that it has little room to grow by reinvesting in its business, and the company may not have much upside. Therefore, the dividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has flexibility to reinvest and grow its business.

High yielding dividend stocks with a low payout ratio (below the market average of 52%), tend to offer a high total return (dividends plus capital gains). While dividend stocks as a group have beaten the market in good times and bad, low payout dividend stocks do even better. A Credit Suisse report tracking stock returns from 1990-2008, showed that high yielding dividend stocks with low payout ratios outperformed all other variations of yield and payout, and they more than doubled the S&P 500's return. (For more, see: Introduction To Dividends: Investing In Dividend Stocks.)

Dividend Stocks are Always Boring

Naturally, when it comes to high dividend payers most of us think of utility companies and other slow-growth businesses. These businesses come to mind first, because investors too often focus on the highest yielding stocks. If you lower the importance of yield, dividend stocks can become much more exciting.

The best trait a dividend stock can have is the potential to raise its dividend (even if the current yield is low). When dividends are increased dramatically, the companies stock price jolts, which is a great start on a total return. Sure, trying to determine whether a dividend stock will go up in the future is not easy, but there are several indicators. 

  1. Financial flexibility. This is common sense. If a stock has a low dividend payout ratio, it obviously has room to increase its dividend. Low capex and debt levels are also ideal. On the other hand, if a company is taking out debt to maintain its dividend, that is obviously a terrible sign.
  2. Organic growth. Earnings growth is one indicator, but keep an eye on cash flow and revenues as well. If a company is growing organically (i.e. increased foot traffic, sales, margins), then it may only be a matter of time before the dividend is increased. However, if a company is simply boosting earnings by cutting costs, then a healthy dividend is less certain.

Take the Walt Disney Company (DIS) for example. It has never looked like a high yielding stock, and even today it only yields 1.23%. However, its dividend has risen a whopping 19% annually, over the past five years, which matches its EPS growth. Of course the yield still looks low, but only because the stock price has quadrupled over the past five years (I doubt shareholders are complaining). For those shareholders who bought Disney stock five years ago, the dividend yield is actually around 4% (based on their initial purchase price of around $31). This is just one example of why limiting your dividend selections to growth stocks, with low payout ratios and good future growth prospects, can lead to an outstanding total return. 

Dividend Stocks are Always Safe

If companies only paid dividends when they were in excellent condition, dividends might truly live up to their "safe" reputation. Of course, that's not the case, as a dividend payment is often used to placate frustrated investors when the stock isn't moving. Plenty of companies have increased their dividends just as their business became more competitive. Best Buy Co Inc. (BBY) has boosted its dividend a few times, even as Amazon.com Inc. (AMZN) has pushed it into a price war that has killed margins. Radio Shack raised its dividend even as it was staring into its eventual demise. For some reason, these dividend hikes placated some investors, even though in both cases it hurt each company's chances of long-term survival.

To avoid dividend traps, always evaluate whether management is paying a dividend for the right reasons. Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. Further, if a yield has popped up due to a sagging stock price, find out why before buying the stock. In 2008, many financial stocks dividend yields were pushed artificially high due to stock price declines. For a moment, those dividend yields looked tempting, but as the financial crises deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in 2008. 

The Bottom Line

Ultimately, investors are best served by looking at dividend stocks the same way they would any other stocks. By simply looking for quality businesses, with the best future earnings potential, you will likely find stocks that can raise their dividend (which should lead to a higher stock price and total return). But if you only look for high yielding stocks, even if their payout is unstable, simply based on the misconception that they are safe, you will get burned. Choose a great business first, and let the dividend yield be a secondary concern.

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