When you own stocks, we believe you should own dividend payers either individually or by purchasing 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, but throughout history dividend payers have provided very attractive total returns (dividends + capital gains) and often exhibit much less volatility than the market itself.
Here is a list of some of the qualities you should look for in a dividend stock. A minimum of 20 stocks in various industries would be ideal, with an emphasis on companies that deliver predictable earnings and dividend growth in any economic environment. Look for some, if not all, of the following characteristics:
- Dividend payout ratio of 65% or less and a consistent payout ratio over the past 10 years. 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. You are looking for not only a payout ratio of 65% or less, but a ratio that has stayed fairly constant over many years. The lower the number the better, but you do want a company that pays out a fair amount of its earnings – a number that is too low should be a warning that the goals of the board of directors might not align with your income needs. Obviously, if the payout ratio gets too high and profits cannot cover the dividend, the company and its dividend may be in trouble. So, leave some margin for error – look for a somewhat moderate payout ratio so that if business stumbles for a quarter or two during a recession, the dividend will still be maintained and hopefully increased. You can find the payout ratio for a company using Value Line, or other online websites like www.dividendinvestor.com. Or, you can calculate the payout ratio yourself. Take the stock’s annual dividend and divide it by the consensus earnings per share.
- Dividend yield 50% greater than the S&P 500’s yield. The current yield for the S&P 500 is less than 2.0%, so look for a stock with a current yield of approximately 3.0%. This is very straightforward – you want income beyond what the market is paying.
- 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 (2% or more). 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 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 (the company has proven it is well managed). It is important to see how a company’s dividend performs during a full economic cycle – expansion and recession.
- 10 consecutive years of earnings growth averaging 5% or more annually. 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.
- Predictable earnings that can withstand recessionary times. If you have access to Value Line either with your own subscription or perhaps through your local library, the earnings predictability rating assigned to each stock is helpful. This is a number from 0 to 100 (100 being the highest rating) and the solid names that provide sustainable, consistent earnings through good times and bad, receive a high ranking. It shouldn’t come as a surprise that names like Coca-Cola, PepsiCo, Procter & Gamble, Johnson & Johnson and Colgate-Palmolive, all earn near perfect scores for earnings predictability.
- Price-to-earnings ratio at or below the market’s multiple. Most financial websites like www.finance.yahoo.com 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.
- A simple-to-understand business model selling products or services familiar to you. We prefer to own companies that our clients are familiar with – companies like Kimberly-Clark, Procter & Gamble, Coca-Cola and Johnson & Johnson all have products that you will find in your own home and these stocks can build a solid foundation for a portfolio. Assuming they meet the other criteria you are looking for, it’s nice to own companies in a business that you understand.
- Cash on the balance sheet. We prefer 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.
- Low beta. 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 minimize the volatility in a portfolio and smooth out what can often be a bumpy ride. The beta for any particular company can be found on nearly any financial Web site. Thankfully, many dividend stocks in the consumer staples, utilities or medical industries show below-average beta readings: Colgate-Palmolive – 0.43, General Mills – 0.6, Johnson & Johnson – 0.48, Coca-Cola – 0.47 and AT&T – 0.56, to name a few.
Dividend Stock Exchange-Traded Funds (ETFs)
Exchange-Traded Funds (ETFs) do not need much of an introduction as they have become wildly popular over the past ten 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 companies you want in your portfolio. One can have better risk control by owning individual dividend-paying stocks and reduced investment costs too, but for many clients we will also own ETFs for diversification purposes.
Exchange-Traded Funds (ETFs) began trading in the early 1990s and quickly gained popularity as investors started looking for less-expensive and more liquid alternatives to mutual funds. Investors, both institutional and individual, could see the benefits of holding a specific group of stocks with lower management fees and intraday price visibility.
Let’s look briefly at the advantages and disadvantages of owning dividend-paying ETFs so you can decide if they are appropriate for you.
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 an individual 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 other managed 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 iShares by 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 any typical stock you might buy. 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 you more flexibility to make purchases and sales during the trading day and not have to wait until the end of the day – and at an unknown 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.
- ETFs can be purchased on margin and sold short. If you are so inclined, you can purchase ETFs, like most stocks, on margin (borrowed money) and sell them short too. This can be an advantage for speculators, but also for more conservative investors who are looking to hedge a portfolio to reduce risk. This can be considered an advantage, but I don’t encourage speculation or utilizing margin for most investors.
- Dividends are reinvested automatically and immediately. Dividends of the companies comprised in an open-ended ETF are reinvested immediately.
- Capital gains tax exposure is limited. ETFs can be much more tax-efficient than mutual funds because most of the tax on capital gains is paid only after the sale of an ETF occurs and this is at the discretion of the investor. Even if the ETF sells or buys shares while attempting to mimic the basket of shares it is tracking, there is typically no taxable distribution to shareholders (unlike some actively managed mutual funds). The reason for this is that in-kind transfers effected in ETFs do not result in a taxable gain, and therefore can be expected to be much lower than mutual funds. Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities at a profit. This distribution amount 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 and 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. It can be a tough concept to grasp, but it’s incredibly important to recognize it happens frequently. 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, and if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line. This is different than closed-end funds because ETFs trade based on supply and demand and market makers will capture the price discrepancy to keep the value of the ETF very close to the underlying securities.
- Predictable income. Dividend-paying ETFs pay income as predictable as the underlying shares. So, 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 retirees or anyone living off the income generated from a portfolio.
Disadvantages of owning dividend-paying ETFs:
- Bid-ask spread can be large. As more niche ETFs are created you might actually find an investment in a low volume index and this could result in a high bid-ask spread. You might get a better price by investing in the underlying stocks themselves, not via the ETF. If you own an ETF or are looking to purchase or sell one that has low volume, be sure to enter a limit order rather than a market order to be sure you don’t get a poor fill as a result of a large bid-ask spread. If you stick to very liquid ETFs that have high daily volume, the bid-ask spread will not be an issue. However, be careful with ETFs that invest in small sectors or foreign markets that might have low volume. Look for highly liquid ETFs with billions in assets that trade frequently.
- Costs are higher than owning individual stocks. Most investors compare trading ETFs with mutual funds, but if you compare ETFs to investing in a specific stock, then the costs are higher. The actual commission paid to the broker, if any, might be the same, but there is no built-in management fee for owning a portfolio of individual stocks like there is with ETFs or mutual funds.
- Dividend yields may not be as high as owning individual stocks. Some dividend-paying ETFs have yields that might not be as high as owning a group of stocks. If you handpick your own portfolio of individual stocks you can focus on the high-yielding companies, for example, and ignore those with lower yields. However, when you buy a basket of stocks via an ETF, you are going to typically track a broad market or sector and you are forced to have part ownership in every stock in the ETF – even those that might pay dividend yields lower than you want.
- More difficult to control risk than with individual shares. If you own a portfolio of ETFs as opposed to a portfolio of individual shares, you may find it is more difficult to control risk. In order to reduce risk, you don’t have the first option I often suggest, and that is to remove the high-beta stocks from the portfolio as the market becomes overvalued. These are stocks that have a beta (measure of volatility) higher than the market itself. Unfortunately, with ETFs you cannot choose to sell any of the underlying holdings – you have to own all of them. So, owning individual shares gives you more flexibility and risk control.
- More difficult to control taxes than with individual shares. If you own a portfolio of individual stocks you certainly have some stocks that have performed better than others and you may have some that show losses. If you have taken a taxable gain in any given tax year and you are looking to offset the gain with a loss, you can sell one or more of your individual stocks to offset the gain. This can be a great advantage when managing money for tax efficiency. However, with an ETF or mutual fund you typically only have a single cost basis for the entire investment – you can’t go into the underlying basket or fund and sell a loser to offset a winner to save money on taxes. The bottom line is that ETFs offer less tax flexibility than owning individual shares – and this is important to consider when managing assets in a taxable account.
- ETFs could encourage you to trade. In some cases an investor may be encouraged to sell an investment at an inopportune time if he or she owns an ETF as opposed to a mutual fund. Here’s an example of how this might happen – suppose you own an ETF and you awake to see the stock market and your ETF plunging by 5%. You panic and enter your sell order and you liquidate your entire holding within seconds. Relieved you go about your day only to discover that the market actually recovered the entire amount later in the day and finished higher. If you had not owned the ETF, rather, a mutual fund, you would not have been able to sell during the downturn since you can only sell a mutual fund at the end of the day. You not only would have had a better price on your sale, but you also might not have been so quick to pull the trigger and sell, if you had owned a mutual fund instead of the ETF. So, for very long-term investors or those who are highly emotional investors (prone to panic), as long as the costs are comparable and the fund is as tax efficient as an ETF, you could consider owning a mutual fund instead of an ETF. Vanguard has ETFs that mirror some of their passively managed mutual funds, and some investors might actually be better served by owning their mutual funds instead of the ETFs.
- Forced to own companies you don’t want. As much as I am a fan of ETFs, it has always bothered me that I have to own a piece of every company in an ETF, even if I don’t believe in the company or would never own the company outright. Again, when you buy an ETF you are buying a basket of stocks or securities and you have to own ALL of the stocks that are in the ETF – you aren’t able to avoid some and choose others as you can with a portfolio of individual shares. So, before you purchase an ETF, you should look into the ETF and see what percentage it owns in each individual company, what the top holdings are, and if the ETF owns companies that you don’t believe in or would rather avoid, then don’t make the purchase. It is difficult to find a dividend-paying ETF that will only comprise companies that you want, but quite easy to find dividend-paying ETFs that have most of their money invested in companies you like. Still, I must say, it does bother me to even have one dollar invested in a company I don’t believe in and that is always the case with ETFs – you don’t get to choose the underlying companies in the ETF.
- Diversification from ETFs will not mitigate risk of loss, perhaps permanent, during bear markets. While ETFs offer broad diversification like traditional mutual funds, they are not immune to price declines and carry the same risks as the holdings that comprise the ETF. While they have many advantages, traditional ETFs will in no way control risk during market downturns and are, in fact, set up to mirror the performance of an index (up or down).