3 Golden Rules to Picking High Quality Dividend Stocks
Looking beyond the dividend yield
Growth stocks have taken a big tumble in this bear market. If you hold a growth stock of any kind, it’s likely you’re down at least 30%, if not more.
At times like these, having dividends to cushion your losses from growth stocks cannot be overlooked.
Here’re 3 rules you can use when you’re buying your next dividend stock.
Rule #1 Dividend Growth > Dividend Yield
The most important rule of all is growing dividends.
Dividend yield is calculated by:
Dividend/ Price
A high yield could mean 1 of 2 things:
Decreasing share price
Increasing dividend
We want the latter, not the former.
If the dividend remains the same but the share price keeps decreasing, the dividend yield will increase. This may mean that the company is not fundamentally sound.
In an ideal scenario, we want to find companies that increase their dividends consistently. If they do, the share price will follow suit.
Some companies have low dividend yields. This is not because these are bad companies, but because the share price has increased at a similar or faster rate than their dividends.
On chasing high yields
Chasing high yields is a sure-fire way to get burned. A high dividend yield alone does not necessarily make a good dividend stock.
S&P 500 High Yield Dividend Aristocrats and the S&P 500 High Yield Dividend Index are 2 benchmarks for dividend growth and high dividend yield.
The S&P 500 High Yield Dividend Aristocrats includes:
Companies with a history of at least 20 straight years of increasing dividends. We use this as a proxy for dividend growth stocks.
The S&P 500 High Yield Dividend Index includes:
Companies we call high dividend payers. We use this as a proxy for high dividend yield stocks.
Exhibit 4 suggests that a significant fewer number of dividend growers cut their dividends compared to high dividend payers (7.2% vs 36.1%).
Exhibit 5 shows that dividend growers tend to perform better than high dividend payers in down markets.
Rule #2 Payout Ratio Less Than 1
The payout ratio tells us how much dividends the company is paying out of its earnings.
If the ratio is more than 1, this means that the company is paying out more than its earnings. It may be a sign that the dividend payment is not sustainable, and may be cut eventually.
Rule #3 Low Debt
Most global securities laws mandates that a company must pay its creditors before paying dividends.
Shareholders are last in the queue. Dividends matter not if the company cannot even service its debts.
If the company has high levels of debt, chances are they are taking out debt to pay your dividends.