In order for dividend investing to work, you first need to make sure you select the best stocks, and that you do it at the best moment.
There is no secret recipe to picking successful dividend-paying stocks, but there are a few things that will make the process easier and more reliable, leading to decisions that are more likely to be profitable in the long run.
What Is a “Quality” Company?
This question can be answered in a thousand and one ways. A quality company can be a company that brings value to its customers and to the market. It might be a company that is showing constant growth. Or it might simply be a company that has a proven track record of success in whatever endeavors they engaged in.
It all depends on where you stand and the lens you use to look at this question. If you have to filter this matter through the most important aspect of dividend investing (long-term reliability), a quality company will usually meet a cumulus of characteristics.
In theory, it’s all very easy: you need a company that does pay dividends and then reinvests those dividends over the years so that you increase your net worth.
However, the quality of the company you are investing is can make or break this simple plan. Otherwise, you might have to face severe cuts in dividend payments, the complete elimination of these payments, or simply stock price depreciation.
The most important characteristics of a good company for dividend investing include the following:
- Consistent profits. If a company records amazing profits one year and drops well below that the next year, it’s a clear sign that it might not be the steadiest business.
- Growth. As it was mentioned before, the best dividend paying companies are not growing at a staggering rate – but they are
steady in the way they do this. This is quite important because you want to invest in dividend stocks that will appreciate over time. In general, look for businesses that show growth expectations that range between 5% and somewhere around 15%. Anything above that might lead to severe disappointments that will eventually hurt your portfolio’s performance.
- Good cash flow. Earnings are one thing, and cash flow is a completely different matter. The first will show you if a company is doing a good job, but the second will actually tell you whether or not that company will actually pay its dividends.
- History. Generally, you should look for businesses that have increased their dividend payments over the past 5 years (or more). This will make it more likely that your chosen company will increase their dividend payments over the next years as well.
- The ex-dividend dates. This is quite significant because buying shares after this date means that you will not be eligible for the current round of dividend payments.
- Debt. Most companies have some form of debt, but you should definitely stay away from those that show excessive debt. As you will see later on, there is a special ratio that should be calculated to help you determine just how indebted a company is. Most of the times, companies with a debt to equity ratio of more than 2 are to be avoided.
- Industry. This is a characteristic that is frequently overlooked, but you shouldn’t make the same mistake. For instance, investing in an oil company might not be the best option, precisely because the entire industry is hanging by a string. With oil reserves running low and new technologies pushing electric cars further (both in terms of performance and in terms of pricing), oil companies might soon find themselves struggling. It might not happen overnight, but it is more than likely that they will not continue to grow any further.
- At the same time, the healthcare industry is likely to boom over the next years. Not only are more and more discoveries made, but with the very numerous Baby Boomer generation aging, it is very probable that health services will be in higher demand over the next decades.
Low CAPEX (Capital Expenditure). Companies with lower capital expenditure are past the phase where they need to constantly reinvest their profits for further growth. Consequently, this means that they are more probable to pay dividends, rather than reinvest their earnings entirely.
This should be put into perspective a little. Some industries (like tech) need constant improvement and growth, so it should be a generally bad sign that a tech company is investing a very small percentage of their earnings into further research and growth. At the same time, companies like this are unlikely to pay dividends anyway, so you might as well avoid them altogether. A decent CAPEX is OK for dividend investing, but if most of the company’s earnings are going into reinvestments, it is best to just move on to another option.
