In order to survive a key investing paradox: to find growth for your assets; you’ll have to ride the stock market rollercoaster with some highs and many drops, think dividend growth investing to answer your concerns. Dividend stocks are a great compromise between both growth from the stock market and steady distributions from fixed income. Before picking up any stocks paying a 5% distribution, there are some rules to follow. After all, I’m sure you don’t want to buy the next Yellow Pages, right?
Rule #1: Look at the Right Ratios
A good dividend stock in your portfolio is one that you will keep for several years. The power of dividend growth investing resides in companies that double their dividend at least every 10 years. This is how you can retire with a dividend portfolio yielding 8%. In order to find this lucky lady, you can start your research by filtering the stock market with the following ratios:
- Dividend Yield >3% (I’m going after yield after all)
- 5 Year Dividend Growth >1% (I want this yield to grow over time)
- Dividend Payout Ratio < 75% (I want sustainable dividend growth)
- 5 Year Annual Income Growth >1% (I want potential for more dividend growth)
- ROE > 10% (I want companies making great investment returns)
- P/E Ratio <20 (I don’t want to pay too much for the stock)
This is how you find stocks paying healthy and sustainable dividends. This won’t lead you to the flavor of the month but sound investments.
Rule #2: Dividend Yield Doesn’t Matter
If there is one ratio that doesn’t really matter it’s today’s dividend yield. Dividend growth is ten times more powerful. What’s the point of buying a stock with an 8% distribution if the company will eventually cut its payout and watch it’s stock value go down the drain? Once a stock pays more than 3%, it should be good enough to be on your radar. If the yield is over 5%, cut it from your list. This is not the kind of investment you are looking for. It may be a coyote ugly.
Rule #3: Don’t Go All-In For Canadian Banks
I’ve seen many investors picking the whole Canadian banking industry and make a portfolio out of it. Not good. Sure our banks have been outperforming the market for the past ten years but you can’t put all your eggs in the same basket. Look for sector diversification to make sure that your whole portfolio won’t be hit by the next bubble.
Rule #4: Add US Stocks
The US stock market includes the most diversification in terms of markets served and products. You just can’t find Canadian companies selling for over $10 billion in 100+ countries. However, you can have a look at Coca-Cola (KO), Procter & Gamble (PG), Johnson & Johnson (JNJ) etc. These companies evolve in the consumer sector and can be a gold mine for dividend growth investors! Keep in mind that if you buy US stocks in your RRSP account, you won’t have to pay withholding taxes on dividend payouts.
Rule #5: You Are Allowed To Cheat
Most DYI investors do so to cut out fees. But I believe there is another reason for that: they like the feeling of trading. Unfortunately, “feeling” is synonymous with emotion. You might have an investing profile that you may follow to the T. But sometimes, it’s fun to cheat a little bit. With roughly 10% of your portfolio, you are allowed to cheat and get out of these strict rules that you set. It’s like having a chocolate bar while you are on a diet. It’s not the end of the world. The two examples where I cheat are selecting stocks with a dividend yield under 3% (there are awesome stocks paying 2.5% and they should be not ignored) or a dividend payout ratio around 80% (if I think revenues are going to grow and bring the ratio back under my guidelines).
Set Your Investing Strategy Based on a Code:
Once you have mastered these 5 rules, it’s time to set your investing strategy as you can’t just buy any stocks featured in the news this morning. Setting a strict investing process is the key for successful dividend growth investors. Having a “code” will be of great help when it’s time to buy or sell a stock. Your code should be simple and concise. Here’s my Dividend Growth Investor Jedi Code to inspire you:
You shall look for healthy food (dividend >3% + dividend growth >0% over 5 years.
You shall prefer steady growth and fast growing success (P/E <15 , ROE >10%);
You shall not be greedy (select stocks with low dividend payout ratio <75%);
You shall combine your strengths to succeed (use the 4 quadrants);
You shall not concentrate too much—open your mind (diversify your portfolio);
You shall control your anger (use beta and sector lists to control diversification);
You shall not cheat, though cheating is not forbidden.
This article has been written by The Dividend Guy Blog and recently wrote a Canadian dividend investing book called Dividend Growth: Freedom through Passive Income. The book focuses on building a strong dividend earning portfolio built with the Quadrant Strategy. It’s a great resource to make your investment process faster and manage dividend stocks without paying too much tax.
Disclaimer: I own shares of KO and JNJ.