The 7-Step Checklist for Picking Top Dividend Stocks
Spotting the Top Dividend Stocks
Have you ever lost a boatload of money in the stock market?
If you’ve invested for any length of time, you can probably raise your hand. Almost every investor has picked up shares of a great-looking company, only to watch shares drop like a rock right after.
Good investing comes down to spotting the right stock at the right time. Of course, that’s easier said than done. The market has a habit of moving up and down unpredictably.
Never mind sifting through all of the company’s filings, analyzing news reports, and following analysts’ ratings. The whole process can be quite overwhelming. Bank of America Corp (NYSE:BAC) might give a company a favorable rating so you get ready to buy, then Goldman Sachs Group Inc (NYSE:GS) publishes a negative report.
Thankfully, there’s an answer: a checklist. I stole this idea from the aviation industry, where checklists have become a staple in airline cockpits. You can think of it as a grocery list of sorts—a line-by-line register of specific items, ensuring that all of the important tasks have been completed.
The same thing applies to investing. Before recommending any stock to my readers, I run each security through my seven-step checklist. This checklist helps you accomplish two things: 1) It keeps you focused on the small handful of factors that really drive investment returns, and 2) It ensures you don’t skip a glaring problem in the underlying business.
So, without further ado, here’s my list.
1. Simple Business: My first question when considering any investment is fairly simple: Can I picture my grandchildren or great-grandchildren using this product? The best businesses have stood the test of time. In many cases, their products and services have remained virtually unchanged. While high-flying tech companies have to invent the next hot gadget every other year, great businesses don’t share this burden.
Likewise, great companies don’t deal in complicated financial derivatives or other financial wizardry. They manage simple, profitable businesses that a child could understand. You probably have some of their products in your household right now. And that’s what leads these firms to crush the broader stock market decade after decade.
2. Wide Moat: A moat is a long-term competitive advantage that allows a business to earn both oversized profits and higher returns over time. Warren Buffett coined the term after he realized that companies that reward investors the most over the long run all had a durable competitive advantage.
These moats can some in one of five forms: low-cost producer, high-switching costs, the network effect, intangible assets, or efficient scale. Regardless of the exact type, the strength and sustainability of a firm’s moat will determine its long-run profitability. If a company has a wide moat, it will be able to prevent rivals from stealing market share and eroding earnings.
3. Great Management Team: When evaluating a management team, I ask myself the following three questions:
- Does management have a policy for spending excess cash?
- Does management set clear metrics to keep itself accountable?
- Does management confess its failures as openly as they trumpet its successes?
If you get good answers to these questions, you know you’re dealing with an open and honest management team that will put shareholders first (a rare trait in the business world).
4. Dividend Growth: If I had to reduce my investment checklist down to just one factor, it would probably be dividend growth. And for good reason. A rising dividend often serves to buoy the share price. A long track record of growing dividends also hints at a profitable business and a shareholder-friendly management team.
According to a study by Ned Davis Research, Inc., a portfolio of companies that initiated or increased their dividends between 1972 and 2016 outperformed the broader stock market almost threefold. (Source: “The Power of Dividends, Past, Present, and Future,” Hartford Funds, last accessed June 4, 2018.)
5. Dividend Payout Ratio: Locking in a great dividend is great. But it doesn’t do investors any good if a company slashes its payout the very next week. A low payout ratio provides protection against dividend cuts. Generally, I look for payout ratios of about 75% or less.
However, this varies by industry. I might be willing to accept a higher payout ratio for a Steady Eddie pipeline business, whose profits come in like clockwork. However, I want more wiggle room from companies in cyclical industries like oil, mining, or automotive manufacturing.
6. Light Debt Load: Firms struggling under heavy debt loads have a habit of folding during tough times. Sure, borrowing money can boost returns in the short run. But if anything goes wrong, these policies can backfire in a hurry. And the only thing I know for sure about business is that things always go wrong.
7. Good Total Return: Note, I did not write “good yield.” Many income investors never look past the upfront payout. They jump to buy any stock with a double-digit distribution, then shun any stock with a low yield. I take a more holistic approach in Passive Monthly Income. This requires looking at a stock’s upfront yield plus its long-term potential growth rates. Even a dividend trickle today can become a raging river of cash flow if given enough time.