We recommend an approach that blends high yield stocks, as well as stocks with a high and sustainable dividend growth rate.
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 should increase the amount that they pay to investors. Eventually, it could surpass what you are receiving from your high yield stocks.
What to Look For
When looking for dividend growth stocks, we look for those companies that have a history of growing their dividend and haven’t cut the dividend in the past. We seek companies with payout ratios less than 50%. This means that they return less than 50% of their earnings to investors in the form of dividends. We see this 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 that has a payout ratio of 100%. This means they pay all their earnings to investors in the form of dividends. In order for this dividend to grow, the company must grow their earnings quarter after quarter, or buy back a meaningful number of shares. Without this, they will be forced to borrow to pay the dividend. For income purposes, we do not recommend investing in the companies who borrow to pay their dividend, as it is likely not sustainable.
Now back to growing earnings, we look for companies that 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, if you bought 100 shares of XYZ at a price of $50 for a total value of $5,000, yielding 3%, you should have $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. Now, your shares only yield you 2%. 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 have in the current market. 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, generally, this is not an investor’s objective when picking high yield stocks.
What to Look For
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 in solid financial condition, and then move to the history of the dividend. Like dividend growth stocks, we look to see if the company has ever cut its dividend, and also look to see the history of the 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. If the company is not generating earnings that are sufficient to cover the dividend, 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 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 at a company’s PEGY, which is the company’s P/E dividend by the long-term growth plus yield. This 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, which includes understanding there is more to consider than a stock’s dividend yield. If you have questions regarding your investment holdings, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at email@example.com.