How to select dividend stocks?

One of the main characteristics of quality dividend stocks is that they have a strong brand name. Strong brand by itself would not provide the type of consistent long-term returns that dividend growth investors expect. Add in a wide economic moat, or a strong competitive advantage, which ensures strong pricing power and the qualitative screen for selecting stocks is complete.

Examples of companies with a wide moat include Coca Cola (KO), whose products are well-recognized worldwide and are desirable by consumers, which are willing to pay extra in order to have that specific brand. The company has been able to realize above average returns on capital, which has also allowed it to generate a lot in excess cash flows, which fuel future dividend hikes. Because of these characteristics, Coca Cola (KO) has managed to raise distributions over the past 48 consecutive years.

Another important characteristic for selecting quality dividend stocks is a history of consistently growing distributions. I like it when a company pays a stable dividends, but I really prefer a company that manages to surprise me by repeatedly raising distributions for many years. This is what truly separates the best companies from the mediocre ones. After all, any company can manage to pay a dividend, but only the best ones with the widest economic moats can afford to grow distributions for many years.

Growing dividends are a function of earnings growth. Companies with wide moats and strong brands are able to pass increases in expenses to consumers over time, while also generating efficiencies through innovation and reinvesting in the business, which leads to higher profits. As a result, these types of companies should do well during inflationary economic conditions, as they would be able to pass cost increases over the consumers, who demand that specific product type. The rising dividend would also provide investors with an inflation adjusted stream of income, which would maintain and grow its purchasing power over time.

Investors wish to select only the best dividend stocks, should also be careful not to overpay for them. The lost decade for stocks was caused exactly because investors bid up stock prices to stratospheric levels, which caused subpar market returns even though fundamentals were improving. As a result, paying more than 20 times earnings for a stock is generally not a very good idea. Another important factor is evaluating the sustainability of the dividend payment. If a company distributes out to shareholders more than 50% of its earnings, that could be a warning sign. As dividend investors, it is important to not only receive the growing stream of dividend income every quarter, but also to ensure that the business we have invested in keeps growing and innovating. A company that simply distributes all of its earnings to shareholders, would have to rely on increased lending and dilutive share sales in order to generate enough cash to grow the operations.

Four outstanding dividend growth stocks, besides Coca-Cola (KO) include Johnson & Johnson (JNJ), Procter & Gamble (PG), Wal-Mart Stores (WMT) and Colgate-Palmolie (CL).

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The company has raised dividends for 48 years in a row. (analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. The company operates in three global business units (GBUs): Beauty and Grooming, Health and Well-Being, and Household Care. The company has raised dividends for 54 years in a row. (analysis)

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. It operates in two segments, Oral, Personal, and Home Care; and Pet Nutrition. This dividend champion has increased dividends for 47 years in a row. (analysis)

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. Wal-Mart Stores has consistently increased dividends every year for 36 years. (analysis)

Last but not least, it is important to spread your risks by diversifying into at least 30 individual investments. Sometimes there might not be 30 bargain dividend stocks in the markets, which is why the process of building a solid dividend portfolio would take time. Investors should start out slow, dollar cost averaging their way in as many positions as practicable, and always be on the lookout for undervalued dividend gems.

Full Disclosure: Long all companies listed above

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