3 Factors for Evaluating Dividend-Paying Stocks

Dividend-paying stocks have been growing in popularity for years now, as legions of retirees are forced to look beyond low-yielding government bonds to maintain their income. So in this latest installment in our Dick Davis Digest contributor interview series, I talked to Dividend Detective Editor and Digest contributor Harry Domash about the most important things to keep in mind when investing in dividend paying stocks. I think the advice he shares below is invaluable, whether you’re an experienced income investor and regular reader of our Dividend Digest or just thinking about adding a dividend-paying component to your growth stock portfolio.

Chloe Lutts: Hi Harry, thanks for talking to me today. To begin at the beginning, when did you start Dividend Detective? Why did you decide to focus on dividend-paying stocks?

Harry Domash: I used to publish a growth stock newsletter called Winning Investing. In the year 2000, when the tech bubble was bursting, I felt I needed to provide subscribers with an alternative to growth stocks, so I added two high-dividend stock portfolios to Winning Investing.

At the end of each year, I would summarize the performance of all of our portfolios for subscribers. I noticed that year after year, even though our growth stock portfolios had their share of rockets during the year, the dividend portfolios produced the best returns with much less fuss.

In the mid-2000s, I started DividendDetective.com as a free site and converted to part free and part Premium a couple of years later. On January 1, 2009, I shut down the Winning Investing newsletter so that I could spend full time on Dividend Detective.

CL: What do you look for in a good dividend-paying investment?

HD: To paraphrase an old adage, the three most important factors for evaluating dividend investment candidates are dividend growth prospects, dividend growth prospects and dividend growth prospects. That said, if a stock is already paying double-digit yields, you might be satisfied just if the dividend remained steady.

The main factors that determine future dividend growth are: 1) ability (will the company generate enough cash to fund its dividends), 2) desire (does the current management want to continue raising their dividends?) and 3) industry and global economic factors (is the company in a shrinking industry such as magazines, or a growing industry such as healthcare, are we heading into a recession or economic growth phase, etc?)

Dividend-stock investing requires a different mindset than growth investing.

For growth stocks, the main thing is a firm’s market position in its industry. Growth investors must know if their stocks are gaining or losing market share vis-à-vis their competitors, or if their products are saturating their markets. This is critical since any slowing of growth vs. expectations will crash growth stock prices. For instance, today, growth investors are pondering how well Apple’s new mini iPad will sell compared to the new Windows tablet.

Dividend stocks, by contrast, have already been around that block. They have survived the fast growth, young upstart phase and now are one of a handful of players with more or less stable market shares in relatively slow growing industries such as food product makers, shopping center operators, hotel property owners or utility companies.

So, dividend investors don’t spend much time analyzing stock price charts, changes in stock analyst earnings forecasts and the like searching for clues pointing to faltering growth. Instead, they pay attention to long-term trends and economic forecasts signaling whether market conditions for their stocks are likely to improve or decline in coming months.

For example, due to improved drilling techniques, the supply of natural gas has increased dramatically in recent years and natural gas prices in the U.S. have dropped considerably. So, dividend investors could look for stocks that would profit from these trends. For instance, natural gas is the main cost factor when making nitrogen fertilizers, plastics and chemicals in general. So U.S. companies in those industries are likely to enjoy higher profit margins as well improving market shares compared to offshore producers who are paying triple U.S. prices for natural gas.

CL: Interesting. Are there any other important differences between growth stock investing and dividend investing?

HD: It’s the earnings per share that gets the headlines when firms report quarterly results. But most high-dividend stocks have large investments in physical assets such a factories, office buildings, pipelines, etc., that must be depreciated when computing earnings, even though the assets may be increasing in value. Further, depreciation costs are bookkeeping entries only; no cash changes hands. Thus, for high-dividend payers, reported earnings are not relevant to a firm’s ability to pay its dividends. Instead, dividend investors must focus on operating cash flow, which is the amount of actual cash that flowed into or out of a firm’s bank accounts related to its basic business operations. Fortunately, that number is easy to find and you won’t need to turn on your calculator to do the analysis.

CL: On the other hand, you have a “Dividend Death List” on your site: what are the red flags that make you suspect these stocks are going to cut their dividends?

HD: The main qualifying factors to get on the Death List are insufficient cash flow to fund existing dividends and/or an expected falloff in future cash flows.

CL: So now that we know what to look for, what’s one of your favorite dividend-paying stocks to buy today?

HD: Like my children, I can’t just pick one. So, I like packaged food maker B&G Foods (BGS), regional amusement park operator Six Flags Entertainment (SIX), American Capital Agency (AGNC), a real estate investment trust that invests in residential mortgages, Oneok (OKE), a regulated utility that also own a major natural gas pipeline operator, and deepwater oil well driller SeaDrill (SDRL).

CL: Okay, now generally, what’s one important piece of advice you think all investors, both income and growth, need to heed?

HD: Commentators and other pundits on stock market TV get caught up in the daily minutiae. Ignore them and focus on longer-term issues. Common sense is your best ally.

CL: What do you see as the biggest challenge in the market right now?

HD: The inability of the Republicans and Democrats in Washington to work together to solve this country’s problems.

CL: Do you think investors primarily interested in income should also include fixed-income assets in their portfolios today?

HD: Yes, and preferred stocks are a good way to do that.

CL: Finally, let us get to know you better—what else do you like to do besides investing?

HD: I live on the Central California coast in Santa Cruz County, which is “the beach” for Silicon Valley. We in Santa Cruz are blessed with live theatre, our own symphony orchestra, art galleries, a wonderful jazz club, some pretty good restaurants, and more than 80 wineries. I have to admit that I overindulge in all of the above.

CL: Sounds like a wonderful place to live! Thanks for talking to us, Harry.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Dick Davis Dividend Digest

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