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Dividend Stock Investing Strategy – How to Choose the Best Dividend Stocks

By Pat S

stock market coins dividendsMany investors find themselves experiencing extreme emotional shifts in concert with the unpredictable rises and falls that come with stock market investing. Anxiety may hit like a ton of bricks when prices fall, while excitement sets hearts racing with exhilaration when they rise.

Those who choose to invest in long-term dividends, however, will not feel this same angst as stock prices shift. These investors know that the financial success of their investment is not based on the vagaries of the market itself, but rather on the long-term success of the company. They believe that the stock price and dividend will eventually rise over the long haul, resulting in huge gains over a long period of time.

So, what type of investor should you be? Should you ride the rollercoaster of short term investing, or settle in for the long haul? Really, it’s all about your personality and financial goals. Read on for some of the how’s and why’s of long-term dividend investing.

What Is a Dividend?

When a publicly traded company earns a profit, the management generally has three choices:

  1. Reinvest the money in the company.
  2. Offer a share buyback.
  3. Offer a dividend to investors.

Frequently, fast growth companies will keep the proceeds and either reinvest their income in the long-term growth of the company or offer a share buyback. Share buybacks increase each investor’s proceeds in the future by decreasing the outstanding shares of stock.

Other companies will issue a dividend, or a share of the company’s profits, which is paid out to investors on a quarterly basis.

Long-Term Dividend Investing

Dividend stock investing does not often provide the short-term capital appreciation of hot penny stocks. Nor does it match the excitement of day trading, which during rapidly rising markets can make these investments seem like stodgy, slow money stocks. Moreover, dividend-paying securities often fall out of favor in rapidly rising bull markets, subsequently regaining a fervent following during turbulent and unpredictable markets. This is due to the relatively moderate growth nature of these securities as well as the slow compounding nature of dividends that can be achieved through a long-term, buy and hold philosophy of dividend stock investing.

However, during slow growth bear markets, more and more investors seek shelter in dividend growth stocks such as blue chip stocks. In addition, the stability that these stocks can offer make them an attractive class of security to include as a component in any portfolio during both harsh and thriving economic times.

Now that you know what dividends are, and how they work in the market, is it the right investing route for you? Here are a few things to consider:

1. The Power of Dividends

When choosing whether or not to begin this type of investing, it is important to understand the hidden power of dividends. Take these dividend facts into account:

  • You can’t fake a dividend. Unfortunately, recent history has proven that “creative accounting” methods can be used to falsely inflate a companies earnings per share and other valuation tools in order to falsely increase share price. Dividends offer protection from these shenanigans. Companies cannot pay out money that they do not have.
  • Dividends protect you from the downside. During a bear market, when prices of many securities fall, dividend-paying stocks actually become more attractive, as their dividend yields effectively increase. This can result in an artificial stock price floor, preventing the huge capital losses that can provoke panic selling.
  • Dividends result in more shares. Using a dividend reinvestment strategy or dividend reinvestment plan (DRIP) will result in each of those incremental payouts building commission free equity in your position, which in turn results in bigger dividend payouts the following quarter.

2. A Strategy for Investors, Not Traders

When choosing a dividend investing strategy, it is important to develop a long-term investor’s mindset. To the dividend investor, a share of stock is a living, breathing piece of a company, not solely a vehicle for capital appreciation. By looking at the investment as such, you will not be disappointed by what will likely be a slower growth rate than non dividend-paying stocks.The most important factors in their overall investing strategies are:

  1. The long-term growth and financial prospects of the company.
  2. The current and long-term financial health of the company.
  3. The health of the company’s dividend and the ability for its payout to increase over time.
  4. Management’s treatment of investors.

3. Successful, Long-Term Investors Choose Dividends

Warren Buffett has been called a value investor. Indeed, he has historically purchased shares of companies when they are being sold at a discount to their inherent worth. But, if you review the top 10 holdings of Berkshire Hathaway, you will also find each position constitutes a dividend paying security. If dividend stocks are the investment of choice for the most successful investor in history, shouldn’t they be good enough for your personal investment portfolio? Buffet loves dividend-paying stocks because they add another, more stable form of capital appreciation above and beyond share price increases.

How to Choose the Best Dividend Stocks

As with any investment, it is imperative to do your research when choosing a dividend stock. The most important things to consider when determining the correct dividend stock for your portfolio are:

1. Long-Term Prospects
Dividend investing is a long-term investing strategy. When asked what his favorite holding period for stocks is, Warren Buffett is reputed to have replied, “forever.” This is a dividend investor’s mindset.

As a dividend investor, you never want to sell because this ruins your long-term investing strategy. So you must carefully choose companies with the long-term staying power and ability to thrive despite economic conditions. Seek corporations that grow, regardless of external economic conditions. Even dividend investors have to sell from time to time, when the underlying business or strategy changes.

2. Financials
If you can’t read a balance sheet, research the company’s bond ratings. You want to invest in the companies with the best credit ratings (investment grade or above). If you are familiar with reading financial statements, you will want to look at all of the traditional valuation tools, including the P/E ratio, price/sales ratio, Enterprise Value/EBITDA, and book value.

The company’s outstanding debt structure will also be important to understand, as a corporation’s creditors will get paid before the shareholders in any financial downturn.

3. Management and Dividend History
Look for companies with management teams that have a reputation for being investor-friendly. Consider the management’s historical treatment of dividends and share buybacks, as well as the ability to navigate difficult financial times. Has management ever suspended or lowered its dividends? Has the company ever missed a dividend payout? Or has the company consistently grown its cash reserves and increased its dividend yield over the years?

4. Competition
If someone will be putting this company out of business in a few short years, there’s no point in owning the shares as a dividend investor. Remember, fads come and go, but excellent companies with long-term staying power have the ability to navigate difficult financial waters while emerging as a leader in their industry. Look for industry leaders with staying power.

Final Word

Long-term dividend investing can be an excellent choice if you are looking to gain big over time. While it doesn’t necessarily provide the instant gratification (or complete devastation) of short-term investing, it does promise a more stable investment strategy. Take a page out of the playbooks of big investors like Warren Buffett, think long-term, research the companies you’re investing in, and your portfolio will significantly benefit.

Do you prefer the long-term growth and stability of dividend investing, or the excitement of short term investing? Share your thoughts in the comments below.

(photo credit: Shutterstock)

Pat S
Pat S is an active duty military officer. On his off time he enjoys working out, reading, writing and spending time with his dog. Pat became interested in personal finance after several costly mistakes early in his military career that could have been avoided by a basic understanding of personal finance.

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  • Jeff Pawlik

    Earnings are an opinion; dividends are a fact.

  • http://compoundingreturns.com Pat S.

    True! Especially with the recent rash of “creative accounting”, I like dividends that much more. You can’t pay out money you don’t have, but you can make thing look really good on paper by changing some numbers.

  • Al Schmotz

    Another interesting way of finding high dividend yield stocks is with a new site I found called Stockfront. They analyze stocks based on different drivers and isolate those factors that make a stock move. So to see the top 5 stocks that are influenced by dividends for example, you can go to their top 5 page: http://www.stockfront.com/top-five.html

    Pretty cool site that I found helpful for my own investing strategy.

  • Don K

    I like this investing approach, but would like to do this within an mutual fund or etf.
    Any ideas where to find such funds investing in dividend producing companies?

  • http://compoundingreturns.com Pat S.

    Check out the SPDR S&P Dividend ETF (SDY). It invests in the top yielding 50 stocks of the S&P, offering fairly low expense ratios, and a current yield of 3.9%.

  • Ken Faulkenberry

    To get the maximum benefit I like to pick individual dividend paying stocks for the Arbor Assset Allocation Model Portfolio (AAAMP). However for those who prefer an ETF the POWERSHARES S&P 500 LOW VOLATILITY (SPLV) is made up of the top 100 lowest volatily stocks of the S&P500, and is packed with quality dividend companies.

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