Dividend investing is more than just selecting the highest dividend stock and then forgetting about it. In fact, investors who simply choose dividend stocks based on yield only, without doing any additional analysis are taking too much risk. This risk could translate into full or partial loss of dividend income coupled with severe losses in principal. As a result, investors who plan on living off dividends for decades should take the time and learn about the business they are investing in. They should also try to purchase quality stocks at attractive valuations, and also hold a diversified portfolio with at least 30- 40 individual securities.
The diversified portfolio will reduce the risk to overall dividend income, should one or two components cut dividends. The detailed analysis of each company should determine whether the dividend is sustainable today, which should reduce the near-term risk of choosing a company that cuts dividends right after purchase.
The analysis of each company should include both quantitative and qualitative characteristics. Quantitative characteristics could include things like trends in earnings per share, dividends, stock prices, and returns on equity. Qualitative characteristics could include any piece of information related to the business that could help you understand the business and where it is going. Strong brands, strong competitive advantages, competitive landscape as well as whether products/services have enough appeal to gain some pricing power for the company are just a few items. In addition, any strategic plans will also add value to the analysis process.
After this analysis is complete, the investor should be able to determine whether the company will be able to deliver earnings growth in the future. After all, without sustainable earnings growth, there is a limit to the levels at which companies can boost dividends. Rising dividends will generate higher yields on cost for astute dividend investors who recognized the opportunity to purchase the right stock at the right times. There are several ways that companies manage to increase earnings:
A few ways companies can grow earnings includes:
- Increase Prices
- Cut Costs
- Sell more products
- Acquire other companies
- Create new products
- Sell or close unprofitable operations
- Share buybacks
Of course, as I have mentioned numerous times on this site, entry price does matter. Purchasing a good company at a fair price is important. I is rarely worth it to overpay even for the best dividend growth stock in the world. The attractive entry price provides the investor with another layer of protection, that limits losses, in the case things do not turn out as expected. In other words, if you have to purchase shares at 20 times earnings or 30 times earnings, it is always wiser to choose the cheaper company. This is particularly true if earnings projections are equivalent. The reason for that is in case dividend and earnings do not grow as expected, after the initial purchase.
The other important trait to have is patience. Sometimes, even the best companies in the world experience short-term turbulence. It is important to study each situation individually, and not succumb to feat and jump ship at the first time of trouble. Without patience, the dividend investor will jump from company to company, and from strategy to strategy, without really letting their capital compound over time. Remember, time in the market is more important than timing the market. Also remember that your portfolio is like a bar of soap - the more you touch it, the smaller it gets.
To put the lessons from this article in action, I have selected a few dividend paying companies, which I am reasonably certain will grow earnings and dividends at least in 2015 and 2016.
Johnson & Johnson (JNJ), is engaged 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 earned $2.84/share in 2004, and grew profits to $5.70 by 2014. The company is expected to earn $6.21 in 2015 and $6.56 in 2016. This dividend king has raised dividends per share for 52 years in a row. The dividend increase announcement is usually in April of each year. I would expect the quarterly dividend to reach 75 - 76 cents/share in 2015. I would the further expect the quarterly dividend to reach 79 - 80 cents/share in 2016. This would be up from 70 cent/share today. I find the stock attractively valued at 16.30 times forward earnings and a yield of 2.80%. Check my analysis of Johnson & Johnson.
PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. The company earned $2.41/share in 2004, and grew profits to $4.59 by 2014. The company is expected to earn $4.75 in 2015 and $5.21 in 2016. This dividend champion has raised dividends per share for 42 years in a row. The dividend increase announcement is usually in May of each year. I would expect the quarterly dividend to reach approximately 70 cents/share in 2015. I would the further expect the quarterly dividend to reach roughly 78 cents/share in 2016. This would be up from 65.50 cent/share today. I find the stock slightly overvalued at 20.40 times forward earnings and yield of 2.70%. Check my analysis of PepsiCo.
Full Disclosure: Long JNJ and PEP
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