The 7 Rules For Safety, Income and Growth

Think the Iran crisis is over? Wall Street seems to think so. Stocks soared yesterday in a broad-based relief rally, as tensions de-escalated in the Middle East. This morning, all three major U.S. stock market indices opened in the green, although stocks pulled back later in the day on weak jobs data.

I’m not so sure the Middle East genie is back in the bottle. Nor do I embrace the popular notion that the trade war is winding down. Investors are dangerously complacent. Tensions between the U.S. and Iran could easily boil over again. As for the “phase one” trade deal, it’s less substantive than officials claim.

Don’t get me wrong. As the Dow Jones Industrial Average today flirts with 29,000, now’s not the time to exit the market. But in the midst of this “Fear of Missing Out” rally, you should at least get cautious.

The smart move now is to increase your exposure to dividend stocks. This asset class provides higher safety, but with plenty of growth and income. Below, I outline seven sure-fire rules to picking the best dividend payers.

Not only are top-quality dividend payers attractive sources of steady income, they also offer the potential for strong growth.

According to research from BlackRock, stocks with high dividends outperform non-dividend payers in all economic conditions, rising more than companies without dividends in bull markets and posting smaller declines in bear markets.

Your Checklist for Greater Wealth

Here are the key factors to consider, when seeking the best high-dividend stocks for your portfolio:

Look beyond yield. A high yield can be a good place to start evaluating stocks with high dividends, but it should never be the only reason you buy. You need to dig deeper and look for companies that can clearly maintain, and preferably grow, dividends over time.

Pay close attention to the company’s dividend history. You want to zero in on the stocks that have paid dividends over long periods. This is a key factor not only in judging the safety of dividends but the quality of the company as a whole.

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After all, a company capable of sustaining its dividend for the long term and growing it at regular intervals is supported by an underlying business that’s capable of generating solid and expanding cash flows.

In addition, a company of this caliber probably has a disciplined management team that shows great care in how it makes use of this cash flow in its capital investment decisions, cost controls and debt management.

I look for companies that have had no dividend cuts in at least the last 10 years, which shows their ability to weather difficult times.

Beware of high payout ratios. Perhaps the most important piece of data for income investors, if we had to identify just one, is the payout ratio. It is calculated by dividing the indicated quarterly distribution rate by the previous quarter’s income per share and is a comparison of dividends to the profits that make them possible.

Generally speaking, the higher profits are relative to the dividend, the better protected that dividend is from setbacks at companies. A low payout ratio, which is the dividend as a percentage of earnings, is consequently the best possible sign that the dividend is indeed safe. Conversely, a high payout ratio is a sure sign of an endangered dividend. I look for a payout ratio of no more than 80%.

Look for rising profits. It goes without saying that you’ll want to make sure the dividend stock you’re considering has a history of steady, or better yet rising, profits. But pay attention to its forecasts for profit growth, as well.

I like to see a projected year-over-year earnings increase of at least 5%. That lets profits and dividends beat inflation and withstand the worst of any future interest rate hikes.

Take the long view. If you’re investing for income, your focus should always be on the health of the underlying business. The best dividend stocks are the ones that are in good shape and growing, so they can maintain and raise their payouts.

Over time, stock prices will follow those dividends higher, so you’ll also pocket capital gains by buying and holding. This approach also leads to less-frequent trading, which cuts your brokerage fees.

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Take a steady-as-she goes stance, even during market downturns. As Warren Buffett once said: “Lethargy bordering on sloth remains the cornerstone of our investment style.”

Focus on revenue reliability. Have the stock’s revenue and dividends held up well during past downturns, such as the 2008 financial crisis? If so, that’s a pretty good reason to be confident of their durability in future market storms.

Examples of dividend-paying sectors with reliable revenues include regulated electric, gas and water utilities, fee-generating energy midstream companies, such as pipelines, and big U.S. telecom firms.

Note that energy companies generally don’t produce consistently reliable revenues, due to their exposure to unpredictable oil and gas prices. However, there are some exceptions, such as large cap oil stocks whose massive scale gives them a big edge when it comes to weathering downturns.

Don’t overlook debt. The payout ratio is important. However, something that’s also crucial to dividend stability is debt. You’ll want to look for companies with healthy balance sheets, including significant cash holdings and low debt.

It’s important to keep in mind that what is considered a high debt level varies by industry. Utilities, for example, typically have higher debt loads because of the large sums they must invest to maintain and grow their operations. However, as noted above, they tend to benefit from more reliable revenue streams.

Most important of all…keep it simple. This tip applies to all investments, not just dividend stocks. Peter Lynch said it best in his 1994 book Beating the Street: “Never invest in anything that you can’t illustrate with a crayon.”

Regulated, U.S.-based utilities stocks are good proxies for dividend growth. Utilities provide essential services, a virtue that tends to make their stocks recession-resistant. They’re also insulated from overseas shocks, such as Middle East tensions or tariff wars.

For our “dividend map” of the best utilities stocks to buy, click here now. These companies are cash cows that generate juicy double-digit yields, year in and year out. If you’re looking for sleep-well-at-night investments, our dividend map is for you.

Questions about portfolio protection? Drop me a line:

John Persinos is the managing editor of Investing Daily and the premium trading service, Utility Forecaster.