Identifying dividend stocks is one thing. It’s the easy thing.
Identifying the right dividend stocks is another. It’s also the hard thing.
Not any old dividend stock will do. Discrimination is a must. You want to invest in only the right dividends. You want to invest only in those dividends that offer the highest probability of maximizing your returns.
How do you identify the right dividend stocks?
I’ve devised four rules to make the difficult manageable. Follow these rules and your probabilities for increasing your dividend stock returns are sure to rise.
Veteran investors will recognize the old Avis rental-car slogan: “When you’re only number two, you try harder.”
Avis was imploring consumers to go with number two – Avis. Do so, and your experience will be all the better. Number two tries harder.
We can apply a similar mindset to dividend-stock investing: Go with number two.
Wellington Management analyzed dividend-stock performance back to 1929. It found that going with number two is a worthwhile strategy.
The second quintile (the second of five) of dividend stocks, that is. The stocks with dividend yields in the second quintile outperformed the S&P 500 Index eight out of the nine periods from 1929 to 2016.
The second quintile is composed of stocks that pay dividends that yield between 6% to 8%. Equity REITs and business development companies (BDCs) offer the most fertile fields for sustainable 6%-to-8% yields. (We offer a cornucopia of such investments at High Yield Wealth.)
Avoid the Stretchers
Brace yourself if you stretch for yield. Better yet, don’t stretch.
You’ll also want to avoid companies that stretch for yield as well. The “number two” strategy is again number one. The “number two” strategy relates to payout ratios.
Wellington Management’s research shows that the first quintile of payout ratios is an average of 70%. These companies pay an average of 70% of their net income to shareholders as dividends.
Less is sometimes more. Less is more with payout ratios. Moderation appears the better strategy.
Ned Davis Research analyzed dividend stocks and found that 57% has been the average payout ratio on the S&P 500 since 1926.
This has been the sweet spot for generating high dividend stock returns. The second quintile outperformed the other quintiles.
The second quintile of payout ratio today, at 46%, is sustainable. What’s more, it has room to expand to the historical average. Number two is again number one.
Incorporate the Growers
If you have time to wait for your dividend stream to rise, then wait with dividend-growth stocks.
Ned Davis Research data (who again I lean on) show that dividend-growth stocks (and dividend initiators) offer the highest returns with the lowest volatility. Dividend-growth stocks beat not only other dividend stocks, they beat all stocks.
Dividend-growth stocks produced a 10.1% average annual return from 1972 through 2018. The return was higher than with all dividend payers (9.3%), dividend payers with no change (7.5%), non-dividend payers (2.8%), and dividend cutters (-0.3%).
What’s more, dividend growers produced the highest return with the least volatility. They offer higher returns. Better yet, you get the higher dividend stock returns without climbing aboard a Six Flags roller coaster.
Reinvest the Dividends
If you don’t need your dividends, don’t spend them. Reinvest them.
Albert Einstein putatively said, “Compound interest is the eighth wonder of the world. He who understands it, earns it . . . he who doesn’t . . . pays it.”
Einstein might be right: Compounding interest is the eighth wonder. If so, then dividend-growth compounded is the ninth wonder. Morningstar data reveal how the wealth-generating power of reinvesting a growing flow of dividends.
Ten thousand dollars invested in the S&P 500 – an index larded with dividend growers – in 1960 grew to $385,273 by the end of 2016. When dividends were reinvested, the same $10,000 returned $2.1 million. This was more than five times the returns when the dividends weren’t reinvested.
Dividend-stock investing is hardly new. The investing strategy has surged to prominence in the past decade due to record-low interest rates. Dividend-stock investing should maintain its prominence when interest rates are no longer at record lows. You’ll want to continue to invest in dividend stocks for income and wealth.