Building a nest egg out of dividend growth stocks and then retiring on the dividend income is one of the most reliable ways to build wealth.
The primary advantage of this strategy compared to pure index funds is that your investment income comes from fundamental business performance and their cash distributions, rather than relying on selling a percentage of your portfolio each year for income at whatever the current market price happens to be.
It’s also one of the most tax-efficient and low-cost ways to invest, and dividend growth stocks historically outperform the market.
This article gives a sample portfolio of dividend stocks I’m willing to buy, including ones I already own and ones I would add fresh capital to now.
It also covers some important dividend stock metrics to look at, and some common mistakes to avoid.
Start from the beginning, or jump to the section you want:
- Picking the Right Stocks: 3 Common Mistakes
- Key Metrics to Look For in Safe High Dividend Stocks
- Sample Portfolio: 15+ Names to Consider
Picking the Right Stocks: 3 Common Mistakes
Normally, stocks with lower dividend yields and faster dividend growth are suitable for younger investors that are looking to maximize total returns, while stocks with higher yields and less growth are suitable for retirees that want to live off the income now.
However, there are a few major pitfalls that investors tend to fall into when they assemble a high-yield portfolio:
Mistake #1) Too Much Sector Concentration
High-yield stocks are commonly found in energy, real estate, utilities, consumer products, and a few other sectors. They’re less commonly found in tech stocks and some other industries.
If you make a requirement that, for example, every stock you pick has to have a 4% yield or higher, you’re seriously limiting your sector exposure, which means you sacrifice diversification and may miss out on where the strongest areas of growth are coming from.
A better approach is to have an overall portfolio average yield in mind, and assemble it that way. For example, it’s smart to pick a master limited partnership yielding 6% per year with slow growth, but then also pick a tech company yielding 2% per year while growing its dividend far faster.
Your average yield in this case would be a solid 4%, and you’d have exposure to traditionally lower-yielding sectors.
A second option is to balance a portfolio with some ETFs. For example, you could assemble a portfolio of high dividend stocks but then also hold 10% of your portfolio in the PowerShares QQQ ETF to provide much-needed tech exposure to your overall portfolio.
Mistake #2) Falling into Liquidity Traps
This mistake is kind of a subset of the previous one, but it’s even more important to be aware of.
Some businesses are net buyers of their own stock, meaning they reduce their share counts over time, which boosts earnings per share and dividends per share. All else being equal, a lower share price benefits their per-share growth because they can buy back a larger percentage of their shares each year with a given amount of money than if their shares were expensive.
Other businesses are net sellers of their own stock, meaning they regularly issue new shares and use that capital to invest in new projects and make acquisitions. Traditionally high-yield industries like real estate investment trusts (REITs), master limited partnerships (MLPs), yieldcos, and business development companies (BDCs) usually fall under this category. They’re paying out most of their cash flow as dividends, so in order to raise new capital and expand they need to issue new shares. All else being equal, they do very well when their shares are expensive.
Here’s the problem. Companies that are heavily reliant on selling shares to fund growth can quickly collapse if their share price gets too low, because they can no longer profitably sell their shares to fund projects. There’s a red line somewhere for each of these net sellers of stock for which they can not grow per-share value by selling new shares to raise capital. For example, if their share prices sink and their dividend yield is 12%, they can’t issue new shares to fund projects that give them only 10% returns. They then have to rely on debt or cutting the dividend to raise liquidity.
Example 1: The Kinder Morgan Debacle
Most dividend investors are aware of what happened to Kinder Morgan (KMI) and a bunch of other MLPs a few years ago.
Kinder Morgan was considered the blue chip version of a master limited partnership; the long-standing gold standard of its industry. They built extensive pipelines throughout the United States, and funded that growth by issuing new units and by using high levels of debt leverage. For a very long time, this was a market-beating strategy with an amazing combo of yield and growth.
But when oil prices cashed in 2014, the industry ran into a serious problem and MLP valuations fell dramatically.
For a normal corporation, this would not have been as big of a deal. But because Kinder Morgan was reliant on continually issuing new shares to fund growth, and its share prices were suddenly cut in half, it quickly fell into a liquidity trap by losing its usual source of new capital. And because they were already highly leveraged, they couldn’t take on too much new debt.
As a result, they had to cut the dividend to reserve liquidity and remain in business, and years later they are still recovering.
Example 2: Pattern Energy is Cutting it Close
I’ve been watching Pattern Energy (PEGI) for some time.
They’re a yieldco that invests primarily in wind projects around the world, and their stock price has been sagging down lately, and has fallen below its IPO price. The dividend yield is well over 9%. The contrarian in me is quite interested:
The problem is, they’re cheap for a reason. A lot of their debt is variable-rate, meaning it will go up with higher interest rates. Their payout ratio is too high, meaning the safety of the dividend is in jeopardy. And most importantly, as their share price continues to sink, they can no longer rely as heavily on issuing new shares to fund their ambitious growth plans.
Here, for example, is what they had to say for their latest quarter:
We continue to have many opportunities for growth; however, we intend to be disciplined in our approach toward new capital given the recent volatility in the capital markets and we intend to pursue alternatives for owning and managing quality projects. The capital we captured from the sale of a minority interest in the Panhandle 2 project in December is just one example of the alternatives we can consider to fund future growth.
Translation: “Our stock price sucks and so we’re at the point of selling existing assets for less than what we paid for them in order to raise fresh capital.”
They should have had a more conservative dividend payout ratio from the beginning.
Now, I’m not saying Pattern will necessarily go the way of Kinder Morgan. I continue to watch this yieldco and they may very well be a deep value play. But it’s an example of a liquidity trap occurring and it’s not a safe investment for a core holding of a retirement portfolio, despite the high yield.
It’s a more speculative high-yield play. High risk, high potential reward. If they can get through 2018 and into 2019, more of their projects should come online and help cover the dividend better, but we’ll see.
How to Protect Yourself
First, only expose a portion of your portfolio to REITs, MLPs, and other businesses that need to continually issue new shares to fund growth. When markets fall, you don’t want to be in a position of having most of your assets turn into liquidity traps.
Second, when you do invest in MLPs, REITs, and similar business models, try to stick to the ones with the least debt and the highest credit ratings. The less leverage one of these businesses has, the more options it has to fund growth during hard times when its equity prices fall to unacceptable levels.
Lastly, because the industry saw what happened to Kinder Morgan, many of the most conservative MLPs and REITs are purposely lowering their dividend/distribution payout ratios over time (not by cutting, but by growing at a slower rate than funds from operations) in order to reach a point where they no longer have to issue new shares/units to fund growth. You can pick businesses that are not-reliant or less-reliant on issuing new shares.
For example, Magellan Midstream Partners (MMP) grows by using internal cash production without issuing any new units, but can still do so as an option if they want. Enterprise Products Partners (EPD) is slowing its dividend growth to get to the point where they are in the same position. Both of them have excellent balance sheets relative to the rest of the industry.
Mistake #3) Complete Lack of International Exposure
The tradition of raising dividends each year, through recessions and all, is historically an American corporate practice.
Many foreign companies pay higher yields, but sometimes they go up, sometimes they go down, and sometimes they stay flat for a while depending on business conditions. American blue-chips tend to want to build 10-year, 25-year, or even 50-year records of consecutive annual dividend increases. And this is attractive for dividend investors.
In addition, because foreign stocks pay their dividend in another currency, even if they raise their dividend it might not translate into higher dollar yields for American investors.
Lastly, foreign stocks are less well-known and comfortable to American investors, so they are often avoided.
The problem here is that sometimes the United States stock market becomes highly overvalued. When this happens, decades of data tells us that mean reversion occurs- the United States market underperforms relative to international stocks for a number of years as valuations rationalize.
Here’s a chart of historical annualized stock performance for Europe, the Pacific region, and the United States, from various decades:
Source: Ben Carlson, CFA
Sometimes one region vastly outperforms another and becomes overvalued, and then lags other regions for a while. As Ben Carlson calculated, if you were to invest in all three equally and re-balance once per year, your total return would be 10.6% per year, slightly higher than any of the three individually. And you’d have fewer no-growth decades.
Right now, the United States is one of the most expensive markets in the world and it’s important to have international exposure where stocks are cheaper and dividend yields are higher.
Here is a chart of the average dividend yields around the world, where blue is high (about 4-5%) and red is low (about 1%):
Source: Star Capital
To add international exposure, American investors can either pick individual global stocks, or you can simply hold a few foreign ETFs to help balance out your individually-selected American stocks.
Safe High Dividend Stocks: Key Metrics
Dividing the annual dividend/distribution by the existing stock/unit price gives you the dividend yield.
About 2-3% is solid, while 4% or higher is fairly high-yield.
Look to see how quickly the dividend grows each year, and how reliable that growth is.
Some companies have literally grown their dividends for over 50 consecutive years. Most specifically, look to see what happened to their dividend during the last recession.
Dividend Payout Ratio
The percentage of earnings that the business pays in dividends is the dividend payout ratio.
The higher the payout ratio, the less safe the dividend is because a small earnings decline would leave the dividend uncovered. But of course, the stability of the cash flows is relevant: MLPs, REITs, and utilities can maintain high payout ratios because their operations tend to be very stable.
For a dividend-growth corporation, try to look for names with payout ratios below 60%.
For REITs and MLPs, try to look for ones where the dividend or distribution is less than 85% of Adjusted Funds From Operations or Distributable Cash Flow (AFFO, or DCF, depending on how they report it) and that have balance sheets better than their competitors. They will have higher valuations and lower yields than some of their shakier peers, but their risk of a dividend or distribution cut is far less.
The total debt divided by the total shareholder equity gives you an idea of how leveraged the company is.
You should also look at Debt/EBITDA and the interest coverage ratio to have a fuller understanding of their financial position, and compare those figures to the company’s competitors.
Return on Invested Capital
The return on invested capital is one of the most important metrics Warren Buffett uses to estimate business performance. Companies with high ROIC for long periods of time likely have an economic moat and a lucrative business model, because they can reliably generate superior returns on their capital, and grow fast.
This metric is better than Return on Equity (ROE) because it takes leverage into account. Looking at the Return on Equity is good for banks and some other industries, but for most companies the ROIC is a more complete assessment of their performance.
Look to see if the number of shares outstanding is decreasing or increasing over time, or staying the same.
A company that is increasing its share count is relying on continually raising new capital, and it would be detrimental for their growth if their share price were to fall. See the above point about liquidity traps.
Sample Portfolio: 15+ Names to Consider
Always do your own due diligence, but here’s a sample portfolio of high dividend stocks I’m bullish on for the long-term, assuming $250,000 invested:
Most of them are safe core holdings. A few of them are more aggressive with risk, but are balanced within the scheme of the portfolio.
Lastly, I use ETFs in the sample portfolio to increase diversification and expand international exposure.
Master Limited Partnerships (EPD, MMP, SEP, BIP, BEP)
With rising interest rates, MLPs, BDCs, and REITs have been beaten down lately, even though historically they do quite fine in higher interest rate environments.
Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), and Spectra Energy Partners (SEP) have some of the strongest balance sheets in the industry, don’t pay any IDRs, have strong distribution coverage ratios, and have held up well in a world with low energy prices.
Brookfield Infrastructure Partners (BIP) and Brookfield Renewable Energy Partners (BEP) are similar to MLPs. BIP is a global infrastructure partnership, and holds assets like utilities, toll roads, and cell towers. BEP is one of the safest yieldcos you can buy, with strong exposure to worldwide hydroelectric assets and other renewables.
Real Estate Investment Trusts (VTR, VNQ)
Rising interest rates have made for great entry prices into REITs.
For this portfolio, I picked a large position in the Vanguard Real Estate Index (VNQ), as well as one of the most defensive healthcare REITs, Ventas (VTR).
Wide Moat Technology Stocks (AAPL, INTC, TXN, MSFT)
While I’m not a huge fan of the valuations here, having exposure to some of the leading dividend-paying tech stocks is important for portfolio diversification.
All of these companies have tremendous returns on invested capital (ROIC) and wide economic moats to sustain them through the business cycle.
Financials (TRV, DFS, SYF, MAIN, LAZ)
Banks and insurers prefer moderately higher interest rates, so it’s good to have exposure to them as rates go up. This part of the portfolio helps balance the REITs and MLPs that prefer lower interest rates.
Discover Financial Services (DFS) and Synchrony Financial (SYF) are credit card lending banks with low valuations, while Traveler’s Companies (TRV) is a major property insurer. Main Street Capital (MAIN) is a high-dividend lender to small and medium businesses, and Lazard (LAZ) is an asset management company that specializes in mergers, acquisitions, and restructuring.
Defensive Picks (SBUX, CLX, RGLD)
Starbucks (SBUX) has growing exposure to China, tremendous returns on invested capital, and usually holds up well during recessions. Clorox (CLX) is a consumer staples company with a variety of brands and significant Latin American exposure.
Royal Gold (RGLD) is one of the safer ways to have some exposure to gold, because they make money from royalty payments from mining companies and have a consistent track record of dividend growth. The yield is low but this is useful as a portfolio hedge.
ETFs (VNQ, VPU, VYMI, IEMG, EWS, RSX, RSXJ)
The Vanguard Real Estate ETF (VNQ) and Vanguard Utilities ETF (VPU) give investors exposure to high-yield industries. The utilities in particular should hold up well over the business cycle.
The other international ETFs provide broad international exposure, especially to emerging markets. Russia and Singapore ETFs offer high yields and provide exposure to reasonably-valued markets. Russia has been beaten down over sanctions and low energy prices, while Singapore serves as a great gateway to Southeast Asia because they have banking assets throughout the region.
Investing in safe high dividend stocks is a smart long-term strategy, at least for a part of your portfolio, especially for people that need reliable investment income or that like to invest in individual companies.
But it pays to be cautious by not concentrating too heavily in certain sectors, not relying too heavily on REITs and MLPs for yield, and not putting all your assets in just your home country’s market. Make sure you are diversified across numerous sectors and countries, that your companies have stronger balance sheets than their competitors, and that only a portion of your holdings rely on continually issuing new shares to fund growth.
You’ll have to sacrifice a little bit of yield for these stronger metrics, but it’ll be well worth it as your portfolio income remains intact through all parts of the business cycle.