15652When you own stocks, you should typically own dividend payers either individually or through exchange-traded funds (ETFs). The risks of stock ownership do not disappear with dividend stocks and there is obviously risk of substantial loss of principal or a dividend cut or elimination. But, when weighing the risks, it certainly makes sense to put the odds in your favor and own consistent dividend payers. The dividend is pretty much all you can count on as far as a return, and even then, it’s no guarantee. Still, throughout history dividend payers have provided attractive total returns (dividends + capital gains) and can exhibit less volatility than the market itself.
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The measure of how much of a company’s profits are paid out in dividends is a key consideration in choosing a dividend stock for your portfolio. A dividend payout ratio of 65% or less and a consistent payout ratio over the past 10 years are attractive. Typically, the lower the number the better, but you do want a company that pays out a fair amount of its earnings. A percentage that is too low should be a warning that the goals of the Board of Directors might not align with your income needs.
Look for stocks that have a dividend yield 50% greater than the S&P 500’s yield. For example, if the S&P 500’s current yield is less than 1.7% look for a stock with a current yield of 2.5% or more.
Look for companies that have 10 consecutive years of dividend growth averaging 5% or more annually. At a minimum, a company’s average annual dividend growth should be greater than the current rate of inflation. Many very established companies like AT&T, Verizon and Consolidated Edison, to name a few, pay much higher than average dividend yields, but don’t grow their dividends by much each year. This can be acceptable, but ideally you want dividend growth to at least keep pace with inflation. And, you want to build a portfolio of companies offering both dividend growth and an above-average current yield. Companies that have grown dividends on average 5% or more each year for the past 10 years should give you the confidence that they can sustain and grow their earnings and dividends even during difficult economic times.
10 consecutive years of earnings growth averaging 5% or more annually is appealing. This is directly correlated to your search for consistent dividend growth, since companies that are unable to grow earnings consistently will not be able to grow dividends either. You will clearly see some overlap in these two categories.
A price-to-earnings ratio at or below the market’s multiple is typically a sign of value. Most financial websites will show you either a 12-month trailing PE ratio for a stock or a 12-month forward PE based on earnings estimates. You can compare this ratio to the market’s multiple (Dow Jones Industrial Average or S&P 500). It is advisable to look for companies that have a PE ratio at or below the multiple of the market. However, keep in mind that great companies may trade at a premium multiple over the market and they often deserve the premium.
It’s preferable to buy companies that have consistent earnings growth, pay growing dividends, and have plenty of cash on the balance sheet. The cash can be used to service or pay down debt, reinvest in operations, repurchase shares or even help temporarily pay the dividend. Many blue-chip dividend payers have a cash hoard in the billions of dollars which provides comfort to investors.
Beta is a measurement of a stock’s volatility relative to the market. The S&P 500 has a beta of 1.0, so any stock with a beta reading under 1.0 will show less volatility than the market. A low-beta portfolio can help reduce volatility.
iStock-1320445028Exchange-Traded Funds (ETFs) do not need much of an introduction as they have become wildly popular over the past twenty years. When I (Stuart) wrote my first book about ETFs in the late 1990s, very few investors had heard of them. Now, most investors are aware ETFs provide an excellent alternative to traditional mutual funds and one could also argue that a portfolio comprised of only dividend-paying ETFs is all the stock exposure you need to help reach your investment objectives. In other words, you could argue against owing any individual dividend companies – simply own them via ETFs that are comprised of the type of companies you want in your portfolio. One can have better risk control by owning individual dividend-paying stocks and reduced investment costs too, but there are many advantages of owning dividend-paying ETFs.
- Diversification. A single ETF can give exposure to a group of equities, market segments or styles. In comparison to a stock, an ETF can track a broader range of stocks, or even mimic the returns of a country or a group of countries. For example, you could focus on dividend-paying companies in Europe or Emerging Markets, or a specific industry. Mutual funds can be diversified as well, but ETFs can give you immediate diversification with the push of a button on your keyboard.
- Low fees. ETFs, which are generally passively managed, have much lower ongoing expenses compared to actively-managed mutual funds. A mutual fund’s expense ratio is usually higher due to costs such as a management fee, accounting expenses at the fund level, service and marketing fees, paying a board of directors, and load fees for sale and distribution. In addition, ETF fees have even declined further in recent years as firms like Vanguard and BlackRock compete for passively managed dollars where cost is all-important. Some ETFs are available for as little as 0.10% in annual expenses. This is less than one-tenth the ongoing cost of many actively managed mutual funds and can make quite a difference over a lifetime of investing.
- Trade like stocks. ETFs trade throughout the day on an exchange, just like a stocks. Mutual funds, on the other hand, are only available for purchase or sale at the end of each trading day, and you usually have to enter your order about an hour prior to the close of trading. So, you actually don’t know what price you are going to get when you enter a buy or sell order on a mutual fund. Who knows what might happen on that particular trading day? Since ETFs trade like stocks, they allow more flexibility to make purchases and sales during the trading day at a known price. Again, ETFs trade at a price that is updated throughout the day. An open-ended mutual fund is priced only at the end of the day, at the net asset value.
- Dividends are reinvested automatically. Dividends of the companies comprised in an open-ended ETF can be automatically reinvested.
- Capital gains tax exposure is limited. ETFs can be much more tax-efficient than mutual funds. Even if the ETF sells or buys shares throughout the year while attempting to mimic the returns of an underlying index, there is typically no taxable distribution to shareholders (unlike many actively managed mutual funds). The reason for this is the ETF wrapper allows for in-kind transfers that do not result in a taxable gain. Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities at a profit. This distribution is made according to the proportion of the holders’ investment and taxable as a capital gain. If other mutual fund holders sell before the date of record, the remaining holders divide up the capital gain, and thus pay taxes even if the fund declined in value and even if they did not sell any of their own shares. This can be a very unpleasant surprise. I have had many discussions with investors who have been shocked when they were distributed a taxable gain by a mutual fund even though they didn’t sell any shares during the year. Bottom line, many actively managed mutual funds are not tax efficient and ETFs, for the most part, are perfectly tax efficient – a huge advantage.
- Lower discount or premium in price. ETFs trade throughout the day at a price close to the value of the underlying securities. If the price is higher or lower than the net asset value, arbitrage will bring the price back in line quickly by market makers.
- Predictable income. If you own an ETF that is invested in high-quality dividend payers, you can be confident that the quarterly dividends will be passed on to you, the shareholder, as if you held the individual shares. This is important for any investor living off the income generated from a portfolio.