This was published in the IS Newsletter, which is sent every week by email. I usually keep the content there exclusive and do not repost it on the website but I was told by many members that I really should post this one on the blog. Since I will be referring to it in future posts, I went ahead with the idea. It will not happen very often though so I would recommend joining our free newsletter if you would like to get access to more content about dividend stocks, ETF’s and technology stocks. It is free:) Simply fill out the form below to join!
There are a multitude of ways to find solid dividend stocks to include in your passive income dividend portfolio. We received a few questions regarding those that we are using and decided to make a list of those criteria. They are in no particular order!
-Current Dividend Yield : Ideally, I consider stocks that pay at least 2% of dividend. Obviously the higher the better but a very high yield might be a sign of trouble so keep that in mind at all times.
-Dividend growth rate (A minimum history of 5 years and ideally over 10 years or more) : One of the more important indicators. You want a company that has increased its dividend by 3-4% per year for some time. That is a sign that your holdings will not only be able to give you a good passive income but that this income will increase by more than the inflation rate.
-Dividend consistency : You want a company that has been consistent in paying its dividend, not a company that pays special dividends once a year . Many companies in the natural resources sector for example pay a low dividend every month or every quarter and then pay a portion of their remaining profits at the end of the year. It can result in significant income for shareholders but is often the first expense to go for these companies when things get tough.
-Dividend momentum: If the company has recently reduced its dividend, I would avoid it if possible .Generally, companies do their best to avoid decreasing their dividend. Why? Because it’s a bad sign towards their investors. If a company has taken this step, you can expect that the dividend might stay there for some time and it certainly does not point towards a payout hike.
-Sales growth : It’s a sign of the company’s health. You can do all kinds of things to show higher profits in the short term and cutting costs is always good but what I look to see is growth. In these more difficult economic times, even small growth is good enough for me and obviously, the more, the better.
-Earnings Growth : Bottom line growth is the only way that a
company will be able to increase its payout over time. Solid dividend stocks
would display earnings growth year after year.
-P/E ratio : Reasonable P/E’s are necessary to avoid capital losses . Depending on the growth that the stock displayed, you would be looking for a P/E ratio that is ideally between 10 and 15. There are exceptions though and you should judge the P/E ratio in tandem with growth in earnings and in sales.
-Margins growth : A company that is seeing its margins diminish could have its earnings/dividends under pressure. Since one of the important characteristics of a dividend stud is for the company to be able to keep its pricing power when we experiment inflation, having a steady or growing margin would be a very good sign.
-Payout ratio : I have written about this on the blog in the recent past, conventional wisdom would encourage you to look for a very low payout ratio (below 40-50%) but I think there are positive signs to having a higher payout ratio, you can read more about it there. One thing that is certain is that you should avoid any stock that has a payout ratio over 80%, especially when the ratio is over 100%. Those are not sustainable over a decade or more, which is the horizon you should be looking at.
-Return on equity : Quality companies are able to make good use of their capital and it’s a very good sign if the company you are looking at can maintain a high ROE. A ratio over 5% is generally the minimum that I am looking for.
-Long term Debt ratio: Does it have a clean balance sheet? After living through the recent credit crisis, you can imagine how important it is for a company to avoid using debt too much. When things get more difficult, either for the company or in the general economy, a lot of debt can put a major strain on the company’s financial’s. Ideally, the company would have a debt to capital ratio under 30%.
-Management: What is their attitude about dividends? Some companies take great pride in paying their shareholders through dividends while others simply consider it a temporary way of using the extra cash. There is a fundamental difference between the two. Obviously, you are looking at buying stock that has a pro-dividend management.
-Trend Analysis score : I have discussed trend analysis in the past and always use it for my technology stock picks but it can be useful for all stock picks. While most of the aspects that I look at are considered “fundamental”, I think it’s important to still consider the technical point of view as well. Some stocks are trending either up or down and you want to avoid buying a stock that has a strong down trend. Ideally, I would buy stocks that have a score of at
least 60 on Ino’s trend analysis. (you can sign up for a free trial here).-Price : This makes little difference but I would only caution against buying stocks that trade at less than 5$. These stocks are generally seen as speculative, have less long term buyers and many bigger institutional clients cannot buy stocks that trade under 5$.
-Trading volume (stay away from stocks that trade too thinly ): This will not be a problem if you buy a stock that is part of a major index like the S&P500 but others might not have enough volume and that would make it difficult for you to get a good price when you trade it. I think looking for stocks that trade over 50,000 shares per day is very reasonable.
-Industry: Is it a declining industry? is it volatile? Some industries such as solar energy are much more promising in the medium to long term than other industries in the manufacturing business for example. It is important to consider the industry and its future perspectives. Another point to consider the competitiveness in the industry. In the telecommunications industry, competition is so fierce that it is putting significant pressure on the earnings power of the companies and thus on the potential for dividend payouts/growth.
-Market Share Is it a dominant player? Does it have good pricing power? It makes a world of difference if you are investing in a market leader, it will result in a holding a company that has better growth opportunities and can come out on top in difficult conditions. Coca Cola and Pepsi are two market leaders that are strong dividend stocks.
-Potential threats to the industry: Certain industries are in a fragile condition either because of upcoming legislation, technologies, etc. For example, the music industry has been through a very difficult decade because of the major changes that the internet caused in the sales of music. Technology could have a huge impact on the movie industry, software companies or others.It’s important to look down the road for such a criteria.
-Potential opportunities: Facebook is not listed yet but we have discussed what the company could become at some point and the tremendous impact it could have on its future earnings. A pharmaceutical company that is doing research on a cancer drug would be another example. A company that evolves in an industry with big potential could be a nice addition to a passive income portfolio.
Fit within your portfolio
-Industry Diversification: You want a stock that helps further diversify your passive income dividend portfolio. If you already have a high concentration invested in the financial sector, you should look elsewhere. There are plenty of good dividend stocks out there and no valid reason to focus only on one sector. Just think of the impact of the recent financial crisis on financial stocks. It was dramatic. The impact on a passive income portfolio invested only in financial stocks would have been tragic for the investor.
-Economic cycle diversification : Some companies perform better in tough economic times, you need a few of these. Holding companies in the utilities sector or in the medical business is a nice hedge because those companies will tend to perform well no matter what the economic reality becomes. That is not necessarily true for companies that are in the luxury business for example.
Is it possible to find a stock that will score high in all 20 of these? Probably not. But this is a good guide to help you find a good dividend stock to include in your passive income portfolio.
I would love to get your comments and thoughts on these!