Just holding 20 or so high dividend stocks doesn’t really make, for me, a well-rounded portfolio.
So, I would use ETFs to increase diversification and expand international exposure.
Vanguard International High Yield ETF (VYMI) gives investors broad access to high yield stocks from outside of the United States, mostly from developed countries. Also look at Global X Superdividend (SDIV).
Singapore (EWS) and Brazil (EWZ) are some of the world’s highest-yielding countries, and provide additional foreign dividend income. Singapore serves as a great gateway to Southeast Asia because they have banking assets throughout the region, while Brazil is one of the most important commodity producers in the world.
For individual stocks the key is to reliably find companies that will continue to grow dividends going forward, rather than ones that will stall or cut their dividends. Also take into account debt reduction and share buybacks into your assessment.
There are hundreds of “10 best dividend stocks for 2024!!!” articles out there that give little snippets on a few random companies, written in about an hour by a freelancer.
Blue chip stocks are large, diversified, recognizable businesses that are market leaders in their industries. Think Apple, American Express & UPS. Companies you know well.
They get their nickname from blue poker chips, which tend to be high-value chips in the game.
Many blue chip stocks pay dividends every year like clockwork. Some of them, called “Dividend Aristocrats" have not only paid dividends, but have grown their dividends every year without fail for at least 25 consecutive years.
When a company earns a profit (the difference between revenue and expenses, simply put), it has five main options for what it can do with it:
- Reinvest in the company to grow their operations and income
- Make acquisitions- use money to buy other companies
- Reduce corporate debt, especially if they have high debt levels
- Buy back shares to increase the value of each remaining share
- Pay shareholders cash dividends that they can spend or reinvest
Reinvest. Smaller, newer companies are often best-served by reinvesting all of their cash into their existing operations. They have significant growth potential, great returns on invested capital, usually have fierce competition, and need to grow fast. Bigger companies already saturate their markets, and are limited in how much of their income can be profitably reinvested into growth.
Acquire. Acquisitions make sense on a limited basis. If there is significant synergy that will unlock additional value, or if they can buy a business for less than they think it’s worth, then a company might do very well by acquiring smaller businesses. They can pay money for the business, and in return they now get to earn all the income that the other business produces, and can change or grow it however they want.
Reduce Debt. Companies issue debt in the form of bonds in order to improve their returns on equity. They borrow money at a low interest rate and invest that money into projects that produce higher rates of return, and pocket the difference. But it’s a fine balance between using appropriate leverage and too much leverage. A company can use incoming cash to reduce its leverage when it’s ideal to do so.
Buybacks. A corporation consists of millions or in some cases billions of individual shares, with each share representing fractional ownership of the company. A company can issue new shares to bring in more capital, but it dilutes the existing shares because each share is now worth a smaller percentage of the company. Alternatively, a company can buy back its own shares and eliminate them, which makes each existing share worth a larger percentage of the company.
Dividends. Lastly, mature companies that produce reliable income can start paying their shareholders directly with cash on a regular basis.
Blue chip companies that pay dividends usually do a combination of all of the above. They reinvest part of their money into growing their business, they keep their debt levels reasonable, they may make some acquisitions, they pay regular dividends, and use any remaining capital to buy back some shares.
Some companies dig a wide economic moat around their operations, turn themselves into capital compounding machines that are highly resistant to both recessions and competitors, and then go on to pay dividends that grow every year like clockwork for decades.
Other ones don’t.
Put simply, the best dividend stocks are ones that:
- Pay a dividend with a good yield, covered by cash flow
- Grow their dividend every year like clockwork
- Have a strong balance sheet to withstand setbacks
- Generate superior returns on invested capital, protected by a moat
Too many investors make the mistake of only looking at past returns. You can’t just look at the past twenty years of a company, see that it has raised its dividend by 10% per year, and extrapolate that into the future and assume it’ll be like that forever.
Another big mistake is that many investors chase yield. They just pick the highest-yielding companies without understanding that the highest yields are often a trap- a company is about to cut its dividend, the market knows it, and the stock price is sinking, resulting in what temporarily looks like a very attractive yield.
A smart analysis needs to have a forward-looking element and utilise a margin of safety.
Key Metrics: Dividend Safety
A 12% dividend yield doesn’t mean much if it’s about to be cut. Usually, extremely high yields means that the company is not currently covering its dividend with cash flow or net income, and that they might have to reduce or eliminate the dividend in the near future.
This often happens when a company used to cover its dividend well, but recently encountered a setback, resulting in a lower stock price, lower earnings, but still the same dividend for now. Investors might buy it thinking it’s a value, when really, smart money knows it’s a value trap.
Dividend Growth
Look at the dividends the company paid per share over the past 5-10 years. Determine what the dividend growth rate has been, and see if it has been still growing well over the past 1-3 years as well.
Then think qualitatively about the business. Is their product or service almost certainly going to be in demand in 10-20 years, or are they at risk of technological or cultural shifts in the near future?
For REITs, MLPs, and other high-yield slow-growth businesses, higher dividend payout ratios up to 80% or 90% are okay, but a bit riskier. When you approach or exceed 100%, that’s when it becomes a problem. Due to the large non-cash depreciation impact on the earning statements of these types of asset-heavy businesses, rather than comparing dividend payouts to net income for these types of assets, compare them to Funds From Operations (FFO), Adjusted Funds from Operations (AFFO) or Distributable Cash Flow (DCF).
Key Metrics: Balance Sheet
One of the main problems that can sink an otherwise successful business is mismanaged debt.
All too often, companies over-leverage themselves due to overconfidence in their business model, or just desperation to grow earnings, and then when they encounter a setback, it all falls apart like a house of cards.
Most banks did this prior to the financial crash of 2008, and most MLPs did this prior to the energy price crash of 2014.
Interest Coverage
By far the most important balance sheet metric is the interest coverage ratio. It’s a measure of how many times over their operating income can pay for their debt interest.
Once interest expense gets too high and the company can’t pay it with incoming cash flow, then they become likely to default on their debt and may have to declare bankruptcy.
In Home Depot’s case, their interest coverage ratio is over 13x, which means their operating income is more than thirteen times higher than the interest they pay to bondholders. That means their debt is very well-covered.
For a very stable high-leverage business like a REIT or MLP, the interest coverage ratio should ideally be above 4x. You can add depreciation and amortisation back to operating income to get an accurate idea of how much the bond interest is covered by incoming cash.
For blue chip corporations, like Home Depot or UPS, you generally want to see interest coverage be 10x or higher, which means they are rock solid.
Debt/Equity
Another big metric to consider is the debt-to-equity ratio. If a company has less long-term debt than they have in equity, that’s a good sign.
Generally speaking, the more leveraged a company is, the higher the interest rates they’ll have to pay on their bonds. This will decrease their interest coverage ratio, resulting in less profit left over for shareholders.
The other factor is stability. Asset-heavy businesses that produce extremely stable incomes, like utilities, need to use higher leverage and can generally use it more safely.
The key factor therefore is to look at here is the trend, more so than the absolute figure. And compare debt levels to the company’s peers.
Sometimes you’ll see a company that seems to be growing sales and earnings at a great pace recently, but then when you look at the balance sheet over the past few years, you’ll find that they’ve piled on a lot of new debt, resulting in a far higher debt/equity ratio than they usually have.
This means that their growth is likely unsustainable; they’ve borrowed extra money to expand rapidly, but now that they are more leveraged, they can’t keep repeating that pattern.
Of course, sometimes taking on additional leverage is a good thing. After the financial crisis when interest rates were lowered to nearly 0% by the Federal Reserve, many corporations took advantage of the low interest rates to issue new debt and expand, kind of like how it made sense for homeowners to refinance their mortgages.
It’s just important to be aware of when growth is coming purely organically, or if a company is relying on increasing leverage to expand or buy back their shares.
Return on Invested Capital (ROIC) and Moats
This is probably the most important bit. It’s what separates the best companies from mediocre ones, and focusing on this metric and ones like it is what made Warren Buffett an even more successful investor than his mentor Benjamin Graham, the father of value investing.
Return on Invested Capital (ROIC) is a measure of how effectively a company invests its money, and gives an idea of how in-demand their products and services are. All else being equal, it’s better to invest in a company that generates high returns on invested capital, like 12% or higher.
Companies with high ROIC for long periods of time likely have an economic moat and a lucrative business model, because they can reliably generate superior returns on their capital, and grow fast.
This metric is better than Return on Equity (ROE) because it takes leverage into account. Looking at the Return on Equity is good for banks and some other industries, but for most companies the ROIC is a more complete assessment of their performance.
A good book to read on this is “The Little Book That Still Beats The Market,” b hedge fund manager Joel Greenblatt.
Normally, stocks with lower dividend yields and faster dividend growth are suitable for younger investors that are looking to maximize total returns, while stocks with higher yields and less growth are suitable for retirees that want to live off the income now.
However, there are a few major pitfalls that investors tend to fall into when they assemble a high-yield portfolio:
Mistake #1) Too Much Sector Concentration
High-yield stocks are commonly found in energy, real estate, utilities, consumer products, and a few other sectors. They’re less commonly found in tech stocks and some other industries.
If you make a requirement that, for example, every stock you pick has to have a 4% yield or higher, you’re seriously limiting your sector exposure, which means you sacrifice diversification and may miss out on where the strongest areas of growth are coming from.
A better approach is to have an overall portfolio average yield in mind, and assemble it that way. For example, it’s smart to pick a master limited partnership yielding 6% per year with slow growth, but then also pick a tech company yielding 2% per year while growing its dividend far faster.
Your average yield in this case would be a solid 4%, and you’d have exposure to traditionally lower-yielding sectors.
A second option is to balance a portfolio with some ETFs. For example, you could assemble a portfolio of high dividend stocks but then also hold 10% of your portfolio in something like PowerShares QQQ ETF to provide much-needed tech exposure to your overall portfolio.
Mistake #2) Falling into Liquidity Traps
This mistake is kind of a subset of the previous one, but it’s even more important to be aware of.
Some businesses are net buyers of their own shares, meaning they reduce their share counts over time, which boosts earnings per share and dividends per share. All else being equal, a lower share price benefits their per-share growth because they can buy back a larger percentage of their shares each year with a given amount of money than if their shares were expensive.
Other businesses are net sellers of their own shares, meaning they regularly issue new shares and use that capital to invest in new projects and make acquisitions. Traditionally high-yield industries like real estate investment trusts (REITs), master limited partnerships (MLPs), yieldcos, and business development companies (BDCs) usually fall under this category. They’re paying out most of their cash flow as dividends, so in order to raise new capital and expand they need to issue new shares. All else being equal, they do very well when their shares are expensive.
Here’s the problem. Companies that are heavily reliant on selling shares to fund growth can quickly collapse if their share price gets too low, because they can no longer profitably sell their shares to fund projects. There’s a red line somewhere for each of these net sellers of stock for which they can not grow per-share value by selling new shares to raise capital. For example, if their share prices sink and their dividend yield is 12%, they can’t issue new shares to fund projects that give them only 10% returns. They then have to rely on debt or cutting the dividend to raise liquidity.
A good example of this was Kinder Morgan when the oil price crashed back in 2014.
Only expose a portion of your portfolio to REITs, MLPs, and other businesses that need to continually issue new shares to fund growth. When markets fall, you don’t want to be in a position of having most of your assets turn into liquidity traps. The good news is that the MLP industry blew up enough times that now many of them are self-financing, and no longer need to issue new shares.
Second, when you do invest in MLPs, REITs, and similar business models, try to stick to the ones with the least debt and the highest credit ratings. The less leverage one of these businesses has, the more options it has to fund growth during hard times when its equity prices fall to unacceptable levels.
Mistake #3) Complete Lack of International Exposure
The tradition of raising dividends each year, through recessions and all, is historically an American corporate practice.
Many foreign companies pay higher yields, but sometimes they go up, sometimes they go down, and sometimes they stay flat for a while depending on business conditions. American blue-chips tend to want to build 10-year, 25-year, or even 50-year records of consecutive annual dividend increases. And this is attractive for dividend investors.
In addition, because foreign stocks pay their dividend in another currency, even if they raise their dividend it might not translate into higher yields for domestic investors.
Lastly, foreign stocks are less well-known and comfortable to domestic investors, so they are often avoided.