There is a lot of information on the web that covers how to select stocks, even dividend stocks. In this post I am going to take the negative angle and present what I feel to be three things that I, as a dividend investor, do not want to see in a dividend stock. In my view, if any of my own dividend stocks exhibit any of these traits then that is a red flag which I need to consider acting on.[ad#tdg-embedded]
1. A Very High Dividend Yield
This one is talked about a lot and it has everything to do with risk. Among other things, a dividend yield is a statement of that company’s individual stock risk. The higher the dividend yield, the higher the risk – typically. I say typically because it is not as simple as looking at a company with a 7% dividend yield and saying that it is more risky. Instead, the investor needs to evaluate that yield against the own company’s historical yield patters. If the company has paid a dividend in the range of 6 – 8% over the past 5 years than the 7% is not out of the norm. However, if the yield is normally 3% for that stock and it is now 7% then something is going on with that company and you better figure out what it is.
2. A High Payout Ratio
First, let’s define what the payout ratio is (source: Investopedia)
The percentage of earnings paid to shareholders in dividends. The payout ratio provides an idea of how well earnings support the dividend payments.
A high payout ratio can spell trouble for that company. Again, this payout ratio must be looked into with consideration given to what the average historical payout ratio for that dividend paying company is.
Typically, a high payout ratio is considered to be in the neighborhood of 60% or higher. Since we are talking about ensuring that the company’s earnings can cover the dividend payment, it makes sense that a company that is paying a high portion of those earnings in dividends can become risky. Especially if that payout ratio has spiked recently. The last thing we want as dividend investors is to own a company that can no longer cover its dividend payments!
3. A Dividend Yield Less than the Market’s Yield
This one will be a bit controversial so I invite readers to chime in using the comments section below.
What I am getting at here is that when you go to buy a dividend stock, then perhaps it does not make sense to buy one with a dividend yield less than the overall markets? Why not simply go out and buy an S&P 500 index fund and get the higher dividend yield right off the bat and cut out your individual stock risk?
As dividend investors who buy individual stocks, we are taking on a higher degree of risks as we are exposed to what is called individual stock risk. Amongst the risks we get from the overall market, economic circumstances, and other factors, we also get the risk of that individual company performing poorly and taking our share price down. As such, it stands to reason that we should be compensated for this risk. One way is to receive a good dividend payment from that company. The higher the dividend payment the better (within reason – see above) to help offset that risk we take.
As of this writing, the SPDR S&P 500 ETF (NYSE:SPY) index is trading at a dividend yield of 2.6%. That would mean that as a dividend investor who believed in this rule you would avoid buying dividend stocks with a a yield less than 2.6%.
The first two things dividend investors don’t want to see in their dividend stocks are pretty common – a dividend yield that is too high and a payout ratio the company cannot afford. The third – a stock with a yield less than the market – is more controversial in nature and I am not totally sure where I stand on this one yet. I have not done enough research to determine it Perhaps over the long term a company with a higher dividend growth rate will help offset the lower yields. Let me know what you think using the comments.