Throughout his book, “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” author Mark Lowe has been making an important point: You should never invest in a stock just because it pays a dividend.
If you want dividend stocks that won’t disappoint you in the future, you need to perform your due diligence. That means studying the fundamentals and the circumstances affecting each candidate stock; in Lowe’s words, “You must ensure that you are investing in companies with outstanding traction and are well-positioned to perform well within its industry or sector, and in the stock market in general.”
He recommended 10 areas of investigation, five of which we discuss in this digest (with five more to follow in another article).
Consistent cash flow
This is the book’s top criterion, the first item to examine when choosing dividend stocks. As we know, dividends are paid out of a company’s cash flow, so no cash, no dividends.
More specifically, investors should look for a company that consistently posts positive cash flow results and reject those that fail to measure up. According to Lowe, we should look for companies that are growing their profits from 5% to 15% per year; outside that range we should be cautious. Higher profitability normally means higher cash flow.
To double-check a company’s growth, look for dividend increases in the past five years. If none are found, then it’s necessary to question that profitability growth rate.
Watch out for too much debt
The measure recommended for assessing debt is the Debt-Equity ratio. Ideally, it will be 1.0; if the ratio gets up to 2.0 it's time to walk away. The author wrote:
“This is actually a no-brainer in stock trading. If the company has too much debt, then it will be compelled to settle its dues first before paying dividends. When the debt becomes due, the company has to raise the funds to service the debt. This can easily affect the volume and frequency of dividend payouts.”
Other metrics for weighing debt are the debt-capital ratio and the net debt-Capital ratio. The book offered this example:
- Company T spent $50 million to upgrade its manufacturing process.
- To finance the purchase, the company used 60% cash and 40% debt.
According to Lowe, the debt-capital ratio should be no higher than 50%, and so Company T is not overborrowing to pay for its new equipment.
How healthy is the industry or sector?
Look at broad trends affecting an industry before buying stocks in it. While the future is essentially unknowable, some trends are quite reliable, including those based on demographics.
For example, the number of people going through each life stage is predictable. In 2019, we are witnessing a very large cohort, the baby boomers, reaching the age when medical services are needed more often. Therefore, health care stocks that pay dividends are good bets for the next 20 to 30 years. That’s not a guarantee every stock in the sector will flourish, but the odds are quite good.
You can check the history of stocks when looking at industries and sectors, but information gleaned from the past is of uncertain value. Lowe pointed to the soft drink industry, where companies like Coca-Cola KO and PepsiCo PEP have been very successful at selling sugared water. But, health-conscious consumers are switching to different beverages and investors need to ask how successful these companies will be at adapting to the new demand.
Look for strong managers and management teams
Investors do not need to know individual managers. Instead, they can see how the company has performed in comparison with its peers in the same industry, as well as in leading market indexes. The author wrote, “More often than not, the stock price will manifest if the company has been doing well under its present executive team.”
In addition, he noted investors can also check for share buybacks when a company’s shares were trading below their average value. This practice reduces the number of shares outstanding, and so each share increases in value. Buybacks also signal management’s confidence the company will continue to thrive. Good buyback programs indicate management is doing well.
Finally, when companies are acquiring other companies, is management venturing into an area outside its expertise? Many otherwise great companies have run into trouble by diversifying into areas beyond their circle of competence.
Strong value propositions
“It is common for young investors to be attracted by dividend stocks that are 'booming' based on its market price," Lowe wrote. "But experienced investors are usually cautious about this because it would appear that you are chasing the market and not the company.”Â
Look instead for companies with strong value propositions, those that deliver valuable products and services to their customers. If you can combine customer loyalty with lower share prices, you have a very good candidate.
Lowe does not mention economic moats, or competitive advantages in this context, but that can be a proxy for value propositions. A strong competitive advantage protects a company’s margins because other companies will find it difficult to make headway with competing products.
Conclusion
To be a good dividend investor, you must be a discerning shopper, not buying stocks because they have an attractive dividend, but because they have strong underlying fundamentals. Without those fundamentals, the sustainability of dividends becomes uncertain.
To check for that underlying strength, Lowe recommended 10 criteria, five of which were listed in this article: consistent cash flow, modest levels of debt, a healthy industry or sector, strong management and a strong value proposition.
In a follow-up digest, we will review the other five criteria laid out in “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks.”
Read more here:
Dividend Investing: The High Dividend Yield StrategyÂ
Dividend Investing: The High Dividend Growth Rate Strategy
Dividend Investing: 6 Considerations
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