I like the idea of using an equity income portfolio for my seven- to 10-year money, as I’d like to get a higher return than the current five-year treasury. How do I go about picking stocks for such a portfolio? What do you look for?
In recent weeks, we’ve discussed taking seven- to 10-year money for certain investors and placing it in an income portfolio to combat the low interest rate environment. When searching for a strategy focused on income from dividends, we recommend an approach that blends both high yield stocks as well as stocks with a high and sustainable dividend growth rate. So what is the difference and how do you evaluate potential stocks?
The purpose behind investing in dividend growth stocks is that you can count on the company to increase the amount that is paid to you for holding the shares. Now these may not have an extremely high dividend yield currently, but over time, they will increase the amount that they pay out to investors and can eventually surpass what you are receiving from your high yield stocks.
When hunting for dividend growth stocks, we look for those companies who have a history of growing their dividend and haven’t cut the dividend in the past. We see companies with payout ratios less than 60%—which means they return less than 60% of their earnings to investors in the form of dividends—as the sweet spot of dividend growth stocks. The reason for this number is that for a company to be able to raise their dividend, there has to be earnings left to pay. Think of a company who has a payout ratio of 100%. This means they pay all of their earnings out in the form of dividends. For this dividend to grow, the company must grow their earnings quarter after quarter or buy back a meaningful number of shares. Without this, how will they pay out more than 100% of their earnings? They will be forced to borrow to pay the dividend and for income purposes, we do not recommend investing in companies who borrow to pay their dividend as it is likely not sustainable. We look for companies who grow their earnings at an equal or higher rate than they grow their dividend to ensure that the dividend is sustainable.
If one of your dividend growth stocks appreciates by a considerable amount, you may want to consider selling it, as it no longer provides you a competitive yield. For example, think if you bought 100 shares of XYZ at a price of $50 for a total value of $5,000 and yielding 3% ($150 in annual income). Shortly after your purchase, the shares appreciate to $75. Now your total value is $7,500; however, you still receive that same $150 in annual income. Your shares only yield you 2% now. There may be better opportunities elsewhere in the market.
The purpose behind investing in high yield stocks is to provide income from your investments, especially in periods of low interest rates like we are in now. As long as you choose high quality high yield stocks, you can usually count on receiving your income quarter after quarter. While these stocks don’t offer much in terms of growth, that is generally not an investor’s objective when picking high yield stocks.
When selecting high yield stocks, quality is crucial for us. Just like when we choose any stock, we look to ensure that each company is financially sound, and then move on to the history of the dividend. Like with dividend growth stocks, we look to see if the company has ever cut its dividend. If the dividend is not reliable, it has no place in a high yield portfolio. We then look at the company’s dividend coverage ratio. Is the company generating earnings that are sufficient to cover the dividend? If not, STAY AWAY. Payout ratio comes into play here as well; however, our target payout ratio is substantially higher than with dividend growth stocks. We look for companies with dividend payout ratios of less than 90%. As long as they are not paying out in excess of 90% of their earnings, we are generally OK with it.
Now as is the case with any investment, valuation should not be overlooked. You don’t want to over pay for any investment, regardless of the strategy. We look for companies with a PEGY—the P/E divided by the long-term growth plus yield—which is an appropriate valuation metric for a dividend paying stock so that yield is taken into account.
At Henssler Financial we believe you should Live Ready, and that includes understanding how your dividend-paying stocks should be evaluated. If you have questions regarding your investments, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at firstname.lastname@example.org.