7 Steps to Pick the Best US Dividend Stocks
A reliable source of passive income.
Dear Investor,
Zee here. As investors, we all love an extra passive income source.
Other than the thrill of seeing a stock you own rise higher and higher in the stock market, receiving passive dividend income from your investments every year is something we all look forward to.
But dividends offer much more than just a feel-good factor; they are a powerful tool for building long-term wealth and achieving your financial goals.
By incorporating dividend-paying stocks into your investment strategy, you can create a more resilient and income-generating portfolio.
The question is: How? Let me unpack..
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Why Dividend Investing?
Dividend investing offers several compelling advantages:
Compounding Returns: When you reinvest your dividends through a Dividend Reinvestment Plan (DRIP), you purchase more shares, which in turn generate more dividends. This creates a powerful compounding effect that can significantly boost your returns over time. It's like a snowball rolling downhill, gathering more and more snow as it goes.
Reduced Volatility: Dividend stocks tend to be less volatile than growth stocks, as most of these stocks are mature companies. During market downturns, dividend income can provide a cushion and help you stay the course.
Passive Income Stream: Dividends provide a regular stream of income that you can use to supplement your salary, cover expenses, or reinvest to accelerate your wealth-building journey. This is particularly attractive for those seeking financial independence or planning for retirement. Imagine just relying purely on your dividend income to cover your living expenses during your golden years.
Inflation Hedge: Inflation erodes the purchasing power of your money over time. Dividend stocks, especially those from companies with a history of increasing their dividends (known as Dividend Aristocrats and Dividend Kings), can help you keep pace with inflation. As companies grow and generate higher profits, they often raise their dividend payouts, helping you maintain your real income.
How do you find these dividend paying gems?
It's not as simple as just chasing the highest yield.
Here are 7 crucial steps to help you identify the best dividend stocks in the US market:
1. Large Cap Stocks
The best dividend stocks are usually large, mature companies with stable revenue, profits, and cash flow. These companies have little growth left in them. Because these companies are no longer expanding aggressively, the majority of their earnings can be returned to shareholders as dividends.
Think of companies like Johnson & Johnson (JNJ), Coca-Cola (KO), or Procter & Gamble (PG). These giants have already experienced significant growth and now focus on maintaining their market position and returning profits to shareholders through consistent dividend payments.
On the other hand, a smaller, high-growth company like Tesla or many biotech firms need more cash and resources to grow and expand their business, leaving less money to pay shareholders dividends (if any).
2. Dividend Payout Ratio is more than 50%
If a company is large, stable and isn't seeking to grow aggressively anymore, then the majority of the profits it makes should be returned to shareholders. So look for a company with a dividend payout ratio of at least 50% or more.
For example, Realty Income Corporation (O), known as "The Monthly Dividend Company," returns over 80% of its funds from operations to shareholders as dividends. Similarly, AT&T (T) has historically maintained payout ratios above 60%.
If a company has a low payout ratio, ask yourself why the company is holding on to the cash. Unless they have a good reason to do so or have a way to generate exceptional returns for shareholders, the majority of profits should be paid out as dividends.
3. Track Record of Consistent Dividends
Consistency is key in dividend investing. Look for companies with a long history of paying and ideally increasing dividends over time. This demonstrates a commitment to shareholder returns and suggests a sustainable business model.
The S&P 500 has two prestigious categories for dividend consistency:
Dividend Aristocrats: Companies that have increased dividends for 25+ consecutive years
Dividend Kings: Companies that have increased dividends for 50+ consecutive years
Examples include:
Coca-Cola (KO): 61 years of consecutive dividend increases
Johnson & Johnson (JNJ): 61 years of consecutive dividend increases
Procter & Gamble (PG): 67 years of consecutive dividend increases
3M Company (MMM): Over 60 years of consecutive dividend increases
This consistent growth can significantly boost your returns through the power of compounding, especially when combined with a Dividend Reinvestment Plan (DRIP), which automatically uses your dividends to purchase more shares.
4. Company's Fundamentals Are Sustainable
Many dividend investors tend to ignore the overall aspects of a company's fundamentals. They choose to focus primarily on the amount of dividends they can receive. This is wrong. While dividend yield is obviously important for someone seeking dividends, it is also important to consider the overall health of the company.
A company with deteriorating fundamentals (e.g., falling revenue, profits, cash flow, fading economic moat, etc.) cannot sustain its dividend payout in the long term. The less revenue and profit it makes, the less dividends it can pay.
For example, General Electric (GE) was once a reliable dividend payer but had to cut its dividend dramatically in 2017 due to declining fundamentals and excessive debt. Conversely, Microsoft (MSFT) has grown its dividend consistently as its cloud computing business has driven strong fundamental growth.
Over time, a company with falling revenues and profits will see its stock price fall when investors realize that the company is no longer performing. This fall in value will eat into any dividend gains you might have had at the start – leaving you back at square one.
So always make sure the dividend company you want to invest in will remain fundamentally strong and robust for many years to come.
5. Company Has Low CAPEX
Capital expenditure (CAPEX) refers to the money a company invests in maintaining or expanding its assets. High CAPEX can eat into profits and reduce the amount available for dividends. As a dividend investor, you prefer to invest in a company with low capital expenditure.
For example, airlines like American Airlines (AAL) and Delta Air Lines (DAL) have very high CAPEX as they need to continually maintain their aircraft and upgrade them to newer models after a certain number of years. This limits their ability to maintain consistent dividend payments during economic downturns. Also, Warren Buffett said to avoid airline companies.
In contrast, companies like Microsoft (MSFT), Visa (V), and Mastercard (MA) have relatively low CAPEX requirements as their business models are more asset-light. Real Estate Investment Trusts (REITs) also tend to have predictable CAPEX for property maintenance.
Look for a company that's able to maintain/grow its business with minimal CAPEX.
6. Stable Free Cash Flow
Ultimately, a company must have real cash (not just profits) to be able to pay dividends to its shareholders. Free cash flow is the cash generated by a business after accounting for operating expenses and capital expenditures. It's the lifeblood of dividends.
Even if a company is profitable but has negative or inconsistent free cash flow, it will have trouble paying stable dividends. A smaller company that is seeking to grow might have negative free cash flow as it expands its business. But a large, stable company that dominates its industry should be producing high amounts of free cash flow year after year.
Examples of companies with strong, consistent free cash flow include:
Apple (AAPL): Generates over $100 billion in annual free cash flow
Berkshire Hathaway (BRK.B): Consistently strong free cash flow from diverse operations
Verizon (VZ): Stable free cash flow from telecommunications operations
7. Yield Must Beat Risk-Free Rate
The dividend yield you receive should beat the risk-free rate of the United States. The risk-free rate is the lowest return you can theoretically get "risk-free" over a period of time.
In the US, if you plan to invest your money for ten years, then the risk-free rate is usually based on the return of the 10-year US Treasury note, which currently trades around 4.0-4.5%. For shorter-term investments, you might compare against the 2-year Treasury note or high-yield savings accounts.
If your dividend yield can't beat your risk-free rate, you might as well put your money in Treasury bonds or high-yield savings accounts since you face less risk growing your money there compared to investing in stocks.
However, remember that quality dividend stocks offer the potential for both dividend growth and capital appreciation over time, which can significantly exceed the risk-free rate in the long run.
Examples of Quality US Dividend Stocks
Here are some examples that meet many of these criteria:
Consumer Staples:
Coca-Cola (KO): ~3.0% yield, 61 years of increases
Procter & Gamble (PG): ~2.4% yield, 67 years of increases
PepsiCo (PEP): ~2.8% yield, 51 years of increases
Healthcare:
Johnson & Johnson (JNJ): ~3.0% yield, 61 years of increases
AbbVie (ABBV): ~3.8% yield, strong pharmaceutical portfolio
Technology:
Microsoft (MSFT): ~0.7% yield but strong growth and low payout ratio
Apple (AAPL): ~0.5% yield but massive free cash flow generation
Utilities:
NextEra Energy (NEE): ~2.8% yield, strong renewable energy focus
Dominion Energy (D): ~5.4% yield, regulated utility operations
REITs:
Realty Income (O): ~5.4% yield, monthly dividends, 600+ consecutive months
Digital Realty Trust (DLR): ~3.4% yield, data center REIT
The Bottom Line
Remember to check these seven criteria whenever you're looking to invest for dividends:
Mid to large cap stocks with stable operations
Payout ratio of 50% or more
Consistent track record of dividend payments and increases
Strong, sustainable business fundamentals
Low capital expenditure requirements
Stable and growing free cash flow
Dividend yield that exceeds the risk-free rate
Disclaimer: All information here is for educational purposes only. This is not financial advice. Please do your own research and speak with a licensed advisor before making any investment decisions. Past performance is not indicative of future returns. How we invest may not suit your investment goals and risk management profile.