Wednesday, May 12, 2010

Four Characteristics of The Best Dividend Growth Stocks

Dividends provide investors with a return on investment even when markets are down. As a result investors get paid to hold their stocks through thick and thin. It is important however to pick a stock selection strategy that fits with your financial goals. A good entry strategy is just the beginning however. Investors should also be following the strategy at all times in order to be successful.

Four important characteristics of successful dividend portfolios include entry and exit criteria, diversification, dollar cost averaging and selective dividend reinvestment.

Entry/Exit Criteria

Under my current entry criteria I am looking for companies which have consistently boosted annual distributions for at least one decade. The next step is screening whether the dividend is adequately covered, and that the dividend payout ratio does not exceed 50%. The only exception to this rule is for certain special investment vehicles such as Master Limited Partnerships, Real Estate Investment Trusts or Utilities, where I look at the trend of the dividend payout ratio. I also check to see whether there is earnings growth over the past decade and whether the company has any sustainable competitive advantage. Once the company yields more than 2.50%, has a price earnings ratio of less than 20 and has a dividend payout ratio of less than 50%, I initiate my position in the stock.

I would hold on to the stock as long as dividend payments keep getting increased regularly and would add to the position on dips. An example of an attractively valued dividend stock is Johnson & Johnson (JNJ). I would only consider selling if the dividend is cut for whatever reason. If the company stops raising the dividend I hold onto the stock, but I stop contributing new money. Currently the three stocks I have stopped contributing new money include M&T Bank (MTB), British Petroleum PLC (BP) and National Retail Properties (NNN). The three companies have failed to raise distributions for more than 4 consecutive quarters, which makes them a hold. An example of stocks I sold due to a dividend cut include American Capital (ACAS), which was sold in 2008 when it announced that it would no longer pay a quarterly distribution.


Traditional dividend stocks included high yielding utility stocks and financials. Most financial stocks cut or completely eliminated dividends over the past two years. If investors should learn one lesson from the financial crisis of 2007 -2009, it should be to diversify your portfolio, in order to generate sustainable dividend income. Canadian Income Trust investors also learned a similar lesson in 2006, after the government decided to phase out the royalty trust corporate structure in 2011, sending stock prices and distributions per unit nose-diving. It is also important to own more than 30 stocks from as many sectors as possible, in order to prevent an unfortunate downturn in one sector or a few stocks from destroying your chances of generating sustainable dividend income. Owning more than 30 stocks makes your dividend portfolio less exposed to individual company risks, although you will still be exposed to overall market risk.

Dollar Cost Averaging

After selecting the stocks to include in your portfolio, it is important to spread your purchases as a precaution to avoid paying too high prices. Few if any investors could time successfully the exact highs and lows in the stock market, which is why having a consistent strategy of making prudent purchases every so often would be a good idea. Even high quality dividend stocks such as Procter & Gamble (PG) are not immune from market fluctuations. Dollar cost averaging would have been very beneficial to investors in 2007 and 2008, although a lump sum investment in 2009 would have been better.

Selective Dividend reinvestment

Dividends could be either sitting there or get reinvested. The beauty of dividends is that it is under the discretion of the individual investor to purchase more stock, buy equity in a different company/investment or spend it another way. I do re-invest only a portion of my stocks directly; most other times however I let my dividends accumulate and I either re-invest in the same stocks or in new stocks that have been on my watch list.

Full Disclosure: Long PG, MTB, BP, NNN, JNJ

Relevant Articles:

- Should you sell after a dividend freeze?
- Dividend Portfolios – concentrate or diversify?
- 16 Quality Dividend Stocks for the long run
- Living off dividends in retirement

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