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Many investors look to dividend stocks as safer way to put their money in order earn a little extra income. If you are new to dividend investor, there are certain steps you should know prior to investing in them. In this article we show you how to invest in dividend stocks using 5 simple steps you cannot ignore.
How to Invest in Dividend Stocks
How to Invest in Dividend Stocks to Maximize Passive Income
Why is Dividend Investing Important?
Dividend stocks ensure that you have a source of regular income even during volatile markets. More importantly, these stocks are generally solid brand names that offer significant protection and add stability to your portfolios that growth stocks can’t give. That’s why we have many informational articles on dividend investing, like the best dividend investing podcasts, the best US value stocks that also pay dividends, and the best dividend investing blogs.
Always Choose Quality
Always invest in companies with a proven track record apart from paying out dividends. They should have strong balance sheets, a good growth record, and is stable. An easy way to look at this is by hunting for companies that are Dividend Aristocrats.
Dividend Aristocrats on the TSX have to meet three criteria:
- Market cap of at least $300 million.
- Have increased dividends for 4 straight years.
- Listed on the TSX and be a member of the S&P Canada BMI.
The requirements are more stringent for companies listed on the US stock exchanges. Stocks are considered Dividend Aristocrats if they have increased dividends consistently for over 25 consecutive years. If you apply the 25-year cut-off to Canadian companies, very few stocks make the cut. A few TSX stocks that meet the 25-year criteria are Canadian Utilities, Fortis and ATCO. They have raised dividends for 50, 48, and 28 years respectively. All three of them are utility companies. This is not really surprising. Utility companies have predictable and largely regulated cash flows.
The 25-year cut-off shows that companies have been through multiple economic cycles and have stood the test of time. Other stocks that meet the 25-year cutoff include Toromont Industries and Canadian Western Bank.
Cheap Stocks Aren’t Value Stocks
There are a lot of cheap stocks that pay dividends. It doesn’t mean that these stocks are good for investing. While it is true that there could be some stocks that are undervalued, the market usually does a good job of determining a stock’s worth. Cheap stocks are cheap because the market doesn’t think they can grow. History is littered with examples of stocks that experts thought as cheap and “expert analysts” kept recommending them for years but they never delivered. These include the likes of Ford Motor, General Motors, Eastman Kodak, etc.
A Huge Payout Ratio is a Bad Sign
There are several companies that pay dividends in high single digits or sometimes even in double digits. While that might seem very enticing to newbie investors, they are often a trap. One of the first checks for an investor should be the company’s dividend payout ratio.
A payout ratio is the percentage of net income that a company pays in dividends. For example, if a company has net earnings of $10 and pays $5 as dividends, its payout ratio is 50%. An average of 50-75% is considered decent. If the percentage goes over 75, it could be a cause for concern as this could mean companies are not reinvesting their surplus funds in the business. There are also companies that pay over 100% of their net income as dividends. You need to take a hard look at these companies before investing in them.
Telecom company Telus has a dividend payout ratio of almost 103%. While the company has a strong business, its EPS growth has stagnated.
Of course, this rule doesn’t apply to REITs (Real Estate Investment Trusts) which are required by law to pay out 90% of their net income as dividends to their shareholders.
Growth Opportunities Matter
A lot of established companies are very good dividend paymasters. But you are not investing in a company because of its history. You want to invest because of their future growth potential. Typically, a company that raises dividends consistently without damaging its payout ratio is a good bet.
How to decide what stocks to avoid? Let’s take an example: There are companies in the oil and gas space who haven’t shown any inclination of expanding to the renewable energy space. Yes, oil prices are high now but the world is surely transitioning towards green energy. A decade down the line, these oil companies will likely see a lot of strife in their business as growth stalls.
Diversify, Diversify, Diversify
Like any other investment, it is important to not put all your eggs in one sector. For instance, companies in the energy space or commodities space are cyclical in nature. When a market downturn hits, and if all your money is invested in one of these sectors, there is a possibility that you will see dividend cuts. This could hamper your source of income, not to mention capital loss.
This article has given examples of companies from the utility sector, finance sector, and energy sector. REITs are also good sources of regular dividends. Defensive sectors like grocery retail and growth sectors like tech should also be explored. When you diversify across industries, it reduces risk and adds variety to your investment portfolio.
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