From an investment perspective, utilities tend to have relatively stable share prices and have limited opportunity for long‑term capital gains. Utilities also tend not to raise their dividend much faster than inflation and generally pay out 60% to 80% of their earnings in the form of a dividend. Although utilities offer limited long‑term capital gains and dividend growth, they tend to offer very high dividend yields to attract investor dollars. Utilities companies currently pay dividend yields between 3% and 6%.
Examples of large utilities companies include Duke Energy Corp (DUK), National Grid Plc (NGG), Southern Co. (SO), American Electric Power (AEP), and Pacific Gas & Electric (PCG).
Real‑Estate Investment Trusts
Real‑estate investment trusts (REITs) are a special type of corporate entity used to own and operate income‑producing commercial real estate, such as restaurants, hotels, malls, warehouses, and hospitals and other medical facilities. REITs can either be publicly traded on a stock exchange or privately held. Publicly traded REITs give individual investors the opportunity to invest in commercial real‑estate projects while maintaining the liquidity of their investment, meaning they can sell their shares on public markets at any time. REITs are required by law to pay out 90% of their earnings as dividends to their shareholders, which means they tend to offer above‑average dividend yields. REITs also have different tax treatment than most other types of dividend stocks, which is addressed in detail in a later chapter.
Publicly traded REITs can either be set up as property REITs (sometimes called equity REITs), where the REIT owns interest in commercial real estate; or as mortgage REITs, where the REIT owns mortgages on commercial real‑estate projects. Property REITs and Mortgage REITs have very different investment characteristics. Property REITs primarily make money by leasing space to commercial tenants and distribute the rent payments they receive as distributions to shareholders. Property REITs generate very predictable income and can make steady dividend payments because their commercial tenants are often locked into multi‑year leases with set payment schedules.
Mortgage REITs borrow money commercially and lend it out to commercial real‑estate projects in the form of mortgages. Mortage REITs make their money on the spread between the interest rate at which they borrow money and the interest rate at which they lend money, which makes them very sensitive to changes in prevailing interest rates. Mortgage REITs tend to do well in declining‑interest‑rate environments where they lock in longer‑term mortgages and can borrow money at increasingly affordable rates as prevailing interest rates lower. Conversely, they tend to do poorly when interest rates are rising and the spread between the rates at which they can borrow money and can loan money narrows.
Mortgage REITs tend to offer much higher interest rates than property REITs, but their share prices and dividend payments tend to be much more volatile than property REITs. Because of the volatility of mortgage REITs and the unpredictability of future dividend payments, many dividend investors avoid investing in mortgage REITs and focus exclusively on property REITs.
Examples of REITs include Public Storage (PSA), Welltower (HCN), Ventas (VTR), AvalonBay Companies (AVB), and Simon Property Group (SPG).
Preferred Stocks
Preferred stock is a special classification of stock ownership that has a higher‑priority claim on a company’s assets, earnings, and dividend payments than common stock does. If a company falls upon hard times, its preferred stock holders must be paid their dividends before common stockholders receive any dividend payments. Preferred stockholders generally receive higher dividend yields than common stockholders, but the dividend payments on preferred stock are fixed and will not grow over time. Preferred stocks are said to have features of both stocks and bonds, because they offer fixed‑income payments and also offer some opportunity for capital appreciation. Preferred shares generally do not come with voting rights in the company that issues them.
Some preferred shares are callable, meaning that the issuer can buy them back after a set date for a pre‑determined share price. If interest rates decline, a company may buy back its existing preferred stock and reissue a new series of preferred stock with a lower dividend yield to save money. If interest rates are rising, a company will be less likely to buy back its preferred shares because it is effectively borrowing money at a below‑market interest rate. Other preferred shares may be converted to common stock on a set date or by a vote of the company’s board, depending on the original terms specified for the preferred stock issue. Whether or not a conversion to common stock is profitable for preferred stock investors largely depends on the market price of the company’s common stock.
Many investors are attracted to preferred stock because of their above‑average yields and stable share prices, although it can be a lot of work to research individual preferred‑stock issuances. In addition to evaluating the company’s prospects, investors must also research the characteristics of the individual preferred‑stock issue they are considering buying. For this reason, many preferred‑stock investors buy preferred‑stock mutual funds and ETFs and delegate the work of selecting individual preferred‑stock issues to professional money managers. Preferred‑stock mutual funds and ETFs generally pay dividend yields between 5% and 8% in today’s market.
For example, the iShares US Preferred Stock Fund (PFF) is a popular ETF that primarily invests in preferred‑stock issuances offered by large financial institutions. It has a dividend yield that hovers between 5% and 6% and currently has a beta of just 0.29, which means its price is only about 30% as volatile as the broader market. It charges an expense ratio of 0.47%, which is in line with the fees charged by other preferred‑stock ETFs.
Business Development Companies
Business development companies (BDCs) are a special type of corporate entity that was created in the 1980s to encourage the investment of publicly traded funds into private equity investments. BDCs invest growth capital into small and medium‑sized businesses in exchange for equity position, much in the way that private equity funds and venture capital (VC) funds do. However, VC funds are typically only accessible to accredited investors who meet very high net worth or income requirements. BDCs are usually publicly traded, which allows anyone to buy shares of them without meeting the accredited investor status requirement.
Business development companies have very specific legal requirements under the Investment Company Act that they must follow. According to Wikipedia, the Investment Company Act “(a) limits how much debt a BDC may incur, (b) prohibits most affiliated transactions, (c) requires a code of ethics and a comprehensive compliance program, and (d) requires regulation by the Securities and Exchange Commission (SEC) and subject to regular examination, like all mutual funds and closed‑end funds. BDCs are also required to file quarterly reports, annual reports, and proxy statements with the SEC.”
Business development companies, just like real estate investment trusts, must distribute 90% of their income to shareholders, but most BDCs distribute as much as 98% of their earnings as distributions so that they can avoid taxation at the corporate level. Because of this profit‑distribution requirement, BDCs tend to offer extremely high dividend yields that can range between 7% and 20%. Don’t be mistaken, though. There is no free lunch here. BDCs are effectively the rocket fuel of the dividend‑investing world. They can offer dividend yields that you can’t find anywhere else, but they are also very volatile, have inconsistent dividend amounts and can blow up in your face if you’re not careful. BDCs invest in privately held micro‑cap companies and can have very wild price swings that make the great dividend payments you receive moot.
Many dividend investors, including myself, avoid investing in BDCs all together because of their wild volatility and inconsistent payout amounts. BDCs can be exciting to watch, but they simply don’t fit the mold most income investors are looking for — established players that have consistent and growing dividend payments over time.
Wrap-Up
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p; Some of the concepts and types of corporate structures in this chapter may be hard to remember at first. Fortunately for you, there’s no quiz at the end of this book. Use this chapter as a reference guide to review dividend‑investing concepts and how different corporate structures work when evaluating individual companies. Always be mindful of the types of corporate structures that companies that you invest in use, because each corporate structure has unique tax rules and investment characteristics.
CHAPTER THREE
How to Select Dividend Stocks
As you begin to research dividend‑paying stocks, you may be tempted to open your favorite stock screener, sort companies by their dividend, and focus on the companies that pay the highest dividend yields. Unfortunately, there is no such thing as a free lunch in the stock market. If a company is paying a dividend yield that is four or five times greater than the dividend yield of the S&P 500, there is a pretty strong chance that the dividend isn’t going to stick around. Companies that offer dividend yields of 7% or greater may seem alluring, but these high yields are often the result of a significant drop in a company’s share price and weak earnings that cannot support the company’s dividend over the long term.
A while back, a friend of mine invested in The Williams Companies (WMB) when it was trading at around $22.00. The company’s share price had taken a major hit and it was paying an annual dividend of $2.56, which works out to a yield of about 11.5%.
As a novice dividend investor, he purchased the stock purely based on the company’s larger‑than‑average dividend. If he had done a little bit more research, he would have realized that the company only earned $0.84 cents per share in 2015 and there was no way that they could sustain their dividend. He received exactly two quarterly dividend payments at $0.64 each before the company announced it was cutting its annual dividend by 69% in the third quarter of 2016.
As an income investor, your goal is to get the best yield available on your money. This can make it very tempting to focus on dividend yield alone, but there are several other criteria that you should use to evaluate divided dividend stocks.
You want to make sure that the company will be able to continue to pay out its current dividend by looking at important financial metrics including a company’s dividend payout ratio, debt, net margins, and return on equity.
You will also want to determine if your dividend is likely to grow in the future, as evidenced by the company’s expected future earnings growth and its history of raising its dividend. You will also want to know whether or not you are paying a fair price for a dividend stock and are getting a historically competitive dividend yield.
Use the criteria outlined in this chapter to evaluate each potential dividend stock purchase and you will have a pretty good idea whether or not the companies you are buying will be able to maintain and grow their dividend over time.
Dividend Yield
Dividend yield is simply the measure of what percentage of a company’s current share price is paid out in dividends each year. Let’s imagine that there is a company called PretendCorp that has a share price of $100.00 and it pays an annual dividend of $2.50. PretendCorp’s dividend yield is 2.5%.
A company’s dividend yield will fluctuate throughout the day as the price of the company’s stock rises and falls with the market. If a company’s stock is doing exceptionally well, its dividend yield will fall as the stock’s share price rises. If PretendCorp’s share price were to rise to $150.00 and its dividend does not change at $2.50 per share, the company’s dividend yield would fall to 1.67%. If a company is getting hammered in the market and its price drops, the company’s dividend yield will rise. If PretendCorp were to post dismal earnings and its share price dropped to $50.00, its dividend yield would rise to 5.0%.
Focus on publicly traded companies that pay a dividend at least 50% higher than that of the S&P 500. As a stock investor who is looking for income, it only makes sense to focus on companies that pay a significantly higher yield than the broad‑market indexes.
As I write this book, the S&P 500 offers a historically low dividend yield of 2.05%. That means the minimum dividend you should be looking for is 3.075% in today’s environment. On the other hand, you should treat companies that pay an unusually high dividend yield with a healthy level of skepticism. If a company’s dividend yield is more than three times greater than the dividend yield of the S&P 500, do extensive research about the company’s commitment to its dividend and its ability to maintain its dividend before investing your money. In today’s environment, that means you should evaluate a company that pays of 6.15% or higher with an extra amount of care and due diligence. Companies that pay extremely high dividend yields often come with outsized investment risks and their dividend may be at risk of being cut, but that doesn’t mean you should avoid dividend stocks with high yields entirely.
I personally focus my effort on companies that pay dividend yields between 3.5% and 6.5%. I consider this the “Goldilocks zone” or sweet spot of dividend yields. Companies that pay dividends in this range offer high‑enough yields to pique our interest as dividend investors, but not so high that the dividend is unlikely to stay around in the future.
History of Dividend Growth
If a company you are evaluating has an attractive dividend yield, the next step is to look at the history of dividend payments. How many years in a row has the company raised its dividend? Has the company ever cut its dividend during a recession? How much does the company raise its dividend every year, on average?
Ultimately, we are looking for reliable dividend payments that are likely to steadily grow over time regardless of current market conditions. If a company has a track record of raising its dividend every year over the course of a couple of decades, there is a strong likelihood that it will continue along the same path of steadily raising its dividend if it is financially able to do so.
When I research a dividend stock, I pay special attention to what happened with the company’s dividend in 2008 and 2009 during the Great Recession. During the six‑month period between September 2008 and October 2009, 46 companies on the S&P 500 reduced or eliminated their quarterly dividend payments. During the same period, 82 S&P 500 companies were able to raise their dividend through the depths of the Great Recession. Granted, some of those increases were token bumps so that companies could boast about their track record of raising their dividends every year. If a company was able to maintain and grow its dividend throughout 2008 and 2009 while the global economy was in bad shape, that’s a pretty good sign that the company is committed to its dividend and will be able to continue to making dividend payments during challenging economic times.
I personally focus on companies that have raised their dividend every year for at least the last 10 years. If a company has raised its dividend 10 years in a row, that is a pretty good indication that the company’s management is committed to growing its annual dividend. You should also read what the company’s management has to say about its dividend in its quarterly earnings reports and other public commentary to make sure that the company will continue to be committed to its dividend in the future. I also focus on companies that have grown their dividend by an average of 5% to 10% over the last three years. I am willing to accept lower dividend‑growth rates on companies that have dividend yields on the higher end of the 3.5% to 6.5% spectrum I target. For companies that have a dividend yield of less than 4%, I will want to see an annual dividend‑growth rate very close to 10%.
How fast your portfolio companies raise their income will have a huge impact on the dividend income created by your portfolio over time. Let’s imagine that you owned a portfolio of dividend stocks that raise their dividend by an average of 7% each year. If you had a dividend portfolio that started out with a yield of 4.5%, you would be receiving dividend payments equal to 10.1% of your original investment after holding them for 12 years. After holding your investments for 25 years, you would be receiving dividend payments equal to 24.4% of your original inv
estment each year.
TIP: You can use MarketBeat.com to look up a company’s annual dividend, its dividend yield, its dividend payout ratio, its forward‑looking dividend payout ratio, its track record of consecutive years of dividend growth, its 3‑year average of annual dividend growth, and other important financial metrics. Simply head on over to MarketBeat.com in your favorite web browser and enter the ticker symbol of the stock you are researching in the search box. When that stock’s company profile page loads, click the “Dividends” tab to access these metrics.
Earnings Growth and Dividend Payout Ratio
A company’s track record of steadily raising their dividend and its management’s commitment to its dividend are always a good sign, but a company may be forced to reduce or eliminate its dividend if the company’s earnings can no longer support its dividend. Dividends are paid to shareholders out of earnings. If a company’s earnings are stagnant on a year‑over‑year basis, the company may not raise its dividend at all or it may merely issue a token dividend increase to maintain its track record of consecutively raising dividends every year. If a company’s earnings decline for several quarters in a row and it must pay out an unsustainably high percentage of its earnings as dividends, its board of directors may be forced to reduce or eliminate its dividend.
The measure which shows what percentage of a company’s earnings is being paid out as a dividend is known the dividend payout ratio. Dividend payout ratio is calculated by taking the company’s annual dividend and dividing it by its earnings per share. For example, Wells Fargo currently pays out an annual dividend of $1.52 per share. The company has posted earnings per share of $4.08 per share over the last four quarters. This would put Wells Fargo’s current dividend payout ratio at a healthy 37.2%.
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