Dividend growth investing is not about exit points, momentum swings, relative strength, sector rotation; instead it is about studying fundamentals, selecting superior stocks and building a portfolio with a long-term horizon. When we buy a dividend stock, we hope to hold it forever. What makes a good dividend stock? Here are some of the things I look for:
Good Business Model
Sell things that people want or need, and do it in such a way that it is difficult or impossible for others to duplicate. There is a reason that pharmaceutical companies, such as AbbVie Inc. (ABBV), are so profitable. With effective drugs under patent that sustain or enhance people's life these companies have a deep moat. Consumer goods companies like Procter & Gamble Co. (PG) and Colgate-Palmolive (CL) manufacture products such as soap, detergent, toothpaste and toilet paper that we just can't do without. Sure, there may be generic substitutes, but over the years many of these products have endeared themselves to consumers who are willing to pay a few cents more for the name brand.Strong Free Cash Flow
Dividends are paid with cash remaining after paying the operating expenses and replacement capital (free cash flow). If a company has trouble meeting these basic needs, then its dividend is perilously at risk. Companies with a low free cash flow payout (FCF) payout are well-positioned to sustain their dividend. Such companies include: AFLAC Incorporated (AFL) at 14.5% FCF Payout, Apple Inc. (AAPL) at 24.0%, Lowe's Companies, Inc. (LOW) at 31.1% and Cincinnati Financial Corp. (CINF) at 30.4%.Acceptable Debt Level
Generating a strong free cash flow is not enough - cash has to be available to be paid as dividends. After the 2008-09 economic downturn, many companies were under pressure to reduce debt to stay within their covenants and try to maintain their debt rating. If a company's excess cash is being used to service debt, there may not be any left over to increase dividends. Companies with a low debt to total capital include: Erie Indemnity Co. (ERIE) at 11.2% Debt to Total Capital, Exxon Mobil Corporation (XOM) at 8.5% and Automatic Data Processing Inc. (ADP) at 29.6%.Good Balance between Dividend Yield and Growth
There is usually a reason why a stock's yield is above average. Often it is the market's way of saying it doesn't believe the company can maintain the dividend. Most people understand this risk. However, there is also risk to a stock that has a high dividend growth rate. To maintain a high dividend growth rate the company has to grow cash available for dividends at the same rate. This is often difficult to do.Here are several companies with a good balance between dividend yield and dividend growth rate: Pepsico, Inc. (PEP) 2.8% yield and 3.4% dividend growth rate, Meredith Corp. (MDP) 6.3% yield and 5.6% growth and Leggett & Platt (LEG) 3.9% yield and 4.3% growth.
For those of us that have invested in dividends for years (decades for some of us), we know dividend growth investing is not a passing fad to be "played" then move on the next hot investment strategy. Part of me will be glad when dividend investing falls out of favor and the masses moves on.
Full Disclosure: Long ABBV, PG, CL, AFL, AAPL, CINF, ERIE, XOM, PEP, MDP, LEG,
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