3 Easy Tips for Picking a Winning Dividend Stock

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Dividends are essential to successful portfolio construction. When you buy shares in a company that pays a dividend, you are investing in a company whose management is confident in its long-term profitability. However, just because a company pays a dividend doesn’t mean that it is going to be a viable long-term investment. Furthermore, just because a company pays a dividend now doesn’t mean that it is going to pay a dividend in the future.

The fact is that while dividend-paying stocks may seem to be safer, or even better than non-dividend paying stocks, we need to perform due diligence on them all the same. Here are a few tips for picking the winners that will provide you with income for years to come.

1. Know how a company is paying for its dividend

Companies can get the cash to pay dividends from all sorts of sources. Some of these sources indicate that the dividend may not be sustainable or that it is not the product of value creation. There are several companies that have paid dividends by issuing stock or by borrowing money.

For instance one of the most popular dividend paying stocks among income investors is Kinder Morgan Energy Partners LP (NYSE:KMP). If you look at the company’s earnings per share, and then if you look at its dividend payout, you’ll quickly see that in most quarters the company hasn’t made enough money to pay its dividend. For instance in the most recent quarter Kinder Morgan’s EPS came in at $0.67 per share, but it paid $1.38 per share in dividends. The additional money had to come from somewhere. It turns out that the company issued nearly $1 billion worth of debt, and the average number of shares outstanding in the first quarter increased by 8 million versus the prior quarter. This indicates to me that Kinder Morgan’s dividend is not coming from profits. Rather it is coming from capital raises.

On the other hand consider a company such as Microsoft (NASDAQ:MSFT). Microsoft earned $0.78/share in the quarter ended December 31, 2013, but it paid just $0.28/share in dividends. This is a sustainable dividend coming from profits. This is the sort of dividend you should look for when constructing an income portfolio.

2. Bigger isn’t necessarily better

Just because a dividend-paying stock pays a very large dividend doesn’t mean that it is better than one that pays a smaller dividend. When you analyze a company that pays a large dividend, you have to ask yourself not just where the money is coming from, but why the dividend is so large. After all, if a large dividend is such a reliable income source, then why haven’t investors bid up shares of the company so that the dividend yield is smaller?

A large dividend can often mean that investors are uncertain that the company will be able to continue to pay it. Consider, for instance, the mortgage REIT Annaly Capital (NYSE:NLY). This stock paid a dividend of about $0.65 per share every quarter a couple years ago, and yet the stock traded at just $18 per share. This meant that the dividend yield was near 15 percent! But had you bought the stock simply because it paid a high dividend you would have lost money — the stock now trades at $11 per share. Furthermore, the company only pays $0.30 per share now.

Going back to the example of Microsoft, this company has paid a dividend of roughly 2 to 3 percent over the past several years, depending on the share price at a given time. The stock has been steadily rising, and so has the dividend.

These two examples show that a small, high quality dividend is superior to a large, low quality dividend.

3. Look for dividend growers

The best dividend companies to own don’t just pay a regular dividend, but they grow their dividends on a regular basis. A company grows its dividend when it grows its profits, and when management believes that this growth is sustainable. Over a long period of time buying companies that grow their dividends can make you a lot of money, even if they are fairly boring companies. For instance a company like Exxon Mobil (NYSE:XOM) isn’t a very fast growing company, but it has been a slow growing company for a long period of time, and it has increased its dividend every year for several decades. Over the past twenty-five years Exxon Mobile has grown its dividend five-fold, and still the company pays a dividend that can be covered several times over by its earnings. This sort of steady long term dividend growth can compound dramatically if you are investing now in order to pay for something in the future such as college tuition or retirement.

Conclusion

Picking quality dividend stocks isn’t easy. One way to pick quality dividend stocks is to be just as discriminating as you would be with any other investment. If you know how a company is paying for its dividend and are confident that it can continue to pay it, and even grow it, then you probably have a winner.

Disclosure: Ben Kramer-Miller is long Exxon Mobil.

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