Sailing Around Hazards En Route to Dividend Stocks

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Stocks that consistently pay dividends can be a great way to generate investment income, especially in down markets like the current one. Everyone from the ultra-rich to retirees on a fixed income can take comfort in dividends--regular payments that companies make to shareholders out of net profits.

In the long term, dividends can make a great difference in total investment returns. A study by Morgan Stanley’s Adam Parker showed that from 1930 through 2012, dividends accounted for 41.8 percent of total return of the S&P 500.

In making the journey to the right dividend stocks, there are numerous hazards you must steer around. As some companies boost dividends to attract investors, the high payments may be the best reason not to buy these stocks.

Here are some things to consider:

  • Assess dividend payouts as part of the company’s overall financial condition. Look for dividends that reflect growth and strength, rather than those that are a strain on a company’s resources. If the company has a high dividend yield and a low share price, there’s usually a problem. In such cases, investors attracted by high dividends often mistake low share prices for a bargain—a sign that value will likely rise--when really, these dividends may be hamstringing the company from making improvements critical to boosting share price. puts dividend payouts in the context of companies’ broader financial picture.

  • Look for a history of steady dividend increases. If a company has paid dividends for a long time without a cut, this is a good sign—as long as it isn’t sacrificing growth to do so. You want regular dividend increases commensurate with growth in earnings. Not only do flat dividends or, worse yet, years with no dividends, mean less income for investors, but this scenario usually discourages investment and punishes share prices. Dividend stocks should be predictable. That’s why they tend to be established, mature companies with solid financials.

  • Avoid the common error of chasing yield. Dividend yield is the measure of what the stock pays out in dividends each year relative to its share price. This measure, expressed as a percentage, is calculated by dividing dividends per share paid out in a given year by the value of one share of stock.

Actually, dividend yield is the last thing to look at when assessing a stock. Yet many individual investors are fixated on it. Invariably, if a stock’s yield is high, it’s too good to be true. The beauty of high yields is like the beauty of the sirens that lured Ulysses and his crew to crash their boat on the rocks—alluring yet dangerous.

Generally, a dividend yield that's 3 percentage points or higher than the average of stocks in a given sector is sign of peril. Some people find stocks with high yields a good value precisely because of the low share prices that push up the dividend yield. But think about it: Why would the company’s directors declare a high dividend if they didn’t need to attract investors to their battered shares? And why aren’t they using the cash to grow the business?

  • Pay attention to the dividend payout ratio--what the company is paying versus what it’s earning. This is the ratio of dividends paid to corporate earnings. Finance nerds express this ratio as the dividend paid per share figure divided by the earnings per share: DPS/EPS. Look for a ratio between 0 and 0.1. A ratio over 1.0 can be a bad sign. Payout ratios are available for any public company on Yahoo! Finance using the key statistics search function. The lower the payout ratio, the better, as this means the company is parting with less of the earnings they need to re-invest to improve and expand.

It's okay to seek higher dividends, as long as they’re healthy. But if dividends are high, you want to be sure the company has a reasonable dividend yield and a low payout ratio.

It’s important to evaluate the payout ratio according to the type of company involved. Younger, faster-growing companies tend to pay low or no dividends because they’re reinvesting heavily. Utilities’ dividends are usually higher because they typically pay most of their earnings as a dividend, as their needs for growth are less and they upgrade equipment gradually.

If you don’t want to do this research, consider a dividend-stock ETF (exchange traded fund). These function basically like index funds, so they mirror the performance of a set portfolio of dividend stocks.

By following these guidelines, you’ll be better equipped to avoid the pitfall of imprudently chasing high dividends, and more likely to succeed in reaping good long-term returns in both share price and dividends. By the way, dividends are taxed at a lower rate than other types of income and can even be tax-free if you’re in a low bracket.

Any opinions expressed in this column are solely those of the author.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.