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How to Choose the Best Dividend Stocks

Jeff Brown

The first choice for any fixed-income investor would be a generous, rock-solid government-backed bond or bank account. But with many of these paying next to nothing, what about that old standby -- dividends?

Past generations doted on dividends, and for many investors dividend income was the main reason to buy stocks. For various reasons, that's not as true today. One is that many long-term investors prefer not to get dividends, because they are taxed in the year they are received. Those investors would prefer to see corporate profits reinvested in ways that will raise the share price, since capital gains are not taxed until the stock is sold.

But some investors, especially retirees, love nothing more than a nice dividend check. If you're counting on stocks to live on, it's a lot easier to have your dividends automatically deposited into your checking account than to raise cash by routinely agonizing over which shares to sell.

[See: The 10 Best REIT ETFs on the Market.]

While a healthy dividend stream can be convenient, most experts caution against making a retirement plan overly dependent on dividends.

"No one should rely on dividend income for retirement," says Alexander Parker, CEO of The Bruxton Helmsley Group in New York. "The reason for this is that dividends are never guaranteed and can be taken away."

Russell Robertson, owner of Alidade Wealth Management in Atlanta, says dividends can be a good way to generate an income that will rise with inflation. But he warns that a rush to dividend payers in recent years, when fixed-income investments were so stingy, has pushed share prices too high -- so what you earn in dividends could be lost if stock prices fall.

"Everyone has turned to dividend payers for income, causing them to become overvalued," he says.

Another problem: dividend yields -- annual dividends divided by share price -- are not especially generous these days.

"Dividend yields today look terrible versus history or normal times," says Jason Lina, a financial advisor with Resource Planning Group in Atlanta.

"The S&P 500 yield, for example, of roughly 2.2 percent, is basically half the historical level," Lina says. "This is just a function of low interest rates around the planet, but creates several important problems. For starters, investors who let their retirement spending be driven by dividend yields have to go search for far more aggressive investments with higher yield."

That, of course, can make the strategy risky.

Still, many individual stocks pay a good deal more than the average, including some solid, well-known firms. AT&T (T) has a dividend of 4.85 percent, and Verizon Comunications (VZ) yields 4.41 percent.

So, if you find dividends appealing, what do you need to know? Here are some key points:

Reaching for yield. With online screeners such as those offered by U.S. News & World Report, you can find stocks that yield in the double digits. In fact, you might find stocks paying 30 or 40 percent, or more.

Beware though, because a super yield is often a sign of trouble. In figuring yield, the dividend is a tally of those paid over the past 12 months, while the share price is current. So if the share price plunges, the dividend yield skyrockets. A company in trouble may slash its dividend, or eliminate it entirely, and the share price could fall further.

"Relying on dividend income for retirement creates a terrible incentive that is likely to result in bad outcomes," Lina says. "If I'm saying I'm just going to spend my dividend income in retirement, I have an incentive to go buy the highest dividend and income-paying investments so I have more money to buy things. The reality is that high dividend and high income investments are often the riskiest investments."

[See: The 9 Best Investors of All Time.]

Stocks versus funds. For a yield that is both generous and safe, you'd need to pick and choose among individual stocks. Unfortunately, that takes a lot of analysis and shopping around. Also, you'd need quite a few stocks -- probably several dozen -- for enough diversification to reduce the risk of loss from one stock going sour.

The solution is mutual funds that specialize in dividend-paying stocks. Such a fund may have 40 or 50 stocks picked by pros. But since they can't all be high flyers all the time, you'll probably have to settle for a yield in the 2 to 3 percent range, which is less than you could make on some really good individual stocks. Of course, you would also profit from any share price gains.

Parker prefers stocks to funds, assuming the investor is adept at stock picking or can count on a good pro.

"If you are investing yourself and/or have limited investing knowledge, by all means use (exchange-traded funds) or mutual funds," he says.

The Vanguard High Dividend Yield index fund, for instance, yields more than 3 percent. Most the major fund companies offer dividend-oriented funds.

Consider the long term. If your goal is steady income for living expenses, you want to feel confident your dividend-paying stocks will keep paying.

"If the company is paying out more than 70 to 80 percent of its net income in a dividend, that should be a red flag," Parker says. An excessive "payout ratio" -- the percentage of earnings paid in dividends -- can even mean that the firm is borrowing money to keep up the payment, and will eventually have to slash or eliminate the dividend to survive, Parker says.

One option: invest in stocks that have a history of dependable dividend payments.

"For companies with long histories of dividend payments, their directors will likely not take a dividend cut lightly," says Matt Hylland of Hylland Capital Management in Virginia Beach, Virginia.

Standard & Poor's compiles a list of "dividend aristocrats" that have increased their dividend payments annually for at least 25 years. Some funds specialize in this type of stock, including ProShares S&P 500 Dividend Aristocrats (NOBL), an ETF that owns all those stocks. Note that dependable income doesn't necessarily mean high income, as this ETF currently yields about 1.9 percent.

Selling shares is no sin. Over the long term, dividend yield is less important than a stock's total return, which is share price gains plus dividend earnings. In fact, there's nothing wrong with a stock that pays no dividends at all so long as the company is doing well. The firm may instead have opted to reinvest profits in research and development, new plants or acquisitions -- moves intended to push up the share price.

A $100 stock that pays a $2 dividend is no more valuable than a $100 stock that becomes a $102 stock. And for most investors, the tax rate on dividends and long-term capital gains is the same, 15 percent.

"I use a total return approach when managing money for clients," says Ben Malick, a financial advisor with Three Nine Financial in Grain Valley, Missouri. "Ultimately, I don't care whether the returns will come from dividends or price appreciation."

So there's nothing wrong with selling shares to raise cash. There's less hassle if you invest in mutual funds rather than individual stocks, because you won't have to pick and choose among your holdings. You could tell your fund company to raise a given amount of cash every quarter, for example.

[See: 11 Stocks that Donald Trump Loves.]

And if you keep a significant cash reserve, you can skip the share sales when prices are down, or get ahead by selling a little extra when prices are up.

Popular Dividend Aristocrats

Stock

Dividend Yield

AT&T T

4.85 percent

Exxon Mobil Corp. XOM

3.31 percent

Chevron Corp. CVX

4.16 percent

Coca-Cola Co. KO

3.07 percent

Johnson & Johnson JNJ

2.76 percent

McDonalds Corp. MCD

2.79 percent

PepsiCo PEP

2.72 percent

Procter & Gamble Co. PG

3.24 percent

Target Corp. TGT

3.26 percent

Wal-Mart Stores WMT

2.75 percent

Stock information correct as of June 9, 2016

Or see U.S. News' list of Dividend Growers



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