Want to create a secure, growing income stream from your dividend stock portfolio? What are the characteristics of the safest dividends? Investors buy dividend stocks for the stable income. So, it’s essential to choose stocks that generate safe, growing dividends.
The characteristics for the safest dividends include:
- stable earnings
- culture of increasing dividends, and
- conservative payout ratio
Stable Business. Stable Earnings.
Behind each stock that pays a dividend is a business. If the business is not profitable, it cannot pay healthy dividends. Which sector or industry is the business in? The type of the business helps us determine whether a business’s earnings are stable or not.
For example, consumer staples and utilities typically generate very stable earnings because there’s a consistent demand for their needed products and services no matter how the economy is doing.
On the other hand, businesses whose profitability rely on commodity prices can fall hard in price. Many energy companies have cut their dividends in this oil rout.
Look at Crescent Point Energy Corp (TSX:CPG)(NYSE:CPG) and Canadian Oil Sands Ltd (TSX:COS) as examples. In 2015, they slashed dividends by 57% and 86%, respectively. What did you expect? Both are expected to earn negative earnings in fiscal year 2015.
There’s a similar situation with regards to falling earnings for the miners such as Teck Resources Ltd (TSX:TCK.B)(NYSE:TCK) and BHP Billiton plc (ADR) (NYSE:BBL)(NYSE:BHP). Falling earnings have led to falling prices for energy companies and mining companies alike.
Look for Stable Earnings
To determine if a business earns stable earnings, look back at least 10 years of its earnings history. Earlier, I mentioned utilities are generally very stable businesses. Taking Southern Co (NYSE:SO) as an example, from 2004 to 2014, its earnings increased 9 years out of 10 compared to the previous year. That’s a very good record.
Look for Stocks with Competitive Advantages
When a business can maintain competitive advantages, it can remain more profitable and possibly prevent new entrants coming into the business. A simple way to determine if a company has competitive advantages is via Morningstar.com.
If you have access to its reports, it provides something called an Economic Moat Rating, either labeled Wide, Narrow, or None. By buying companies with a wide or narrow rating, you are building a more solid portfolio.
Look for Businesses with Financial Strength
Credit ratings are useful because at a glance you can tell whether a company is likely to default or not. The higher the rating, the stronger the financial strength of a company. The highest rating is AAA.
For example, Teck Resources has a S&P credit rating of BB, while BHP Billiton plc’s is A+. So, if I must get exposure for a diversified miner, I’d go for BHP Billiton over Teck Resources. Other than S&P, Morningstar also provides credit ratings.
Morningstar credit ratings can be found on a stock’s profile page if it has be rated. Here’s an example with Southern Co.
For long-term investments, I would only buy a stock that has a credit rating of at least BBB+ from either S&P or Morningstar. However, a BBB rating indicates investment-grade quality.
Having a choice between Teck Resources, BHP Billiton, and Southern Co for an income investment, it’s a no-brainer to choose Southern because not only is it financially strong, but it also has stable, growing earnings.
Culture of Increasing Dividends
Just because a business grows its earnings, it doesn’t mean it’ll increase its dividend. For example, Canadian Pacific Railway Limited (TSX:CP)(NYSE:CP) has increased earnings per share 28% or higher from 2012 to 2014. Yet, it hasn’t increased dividends for 14 quarters already.
On the contrary, there’s its competitor, Canadian National Railway Company (TSX:CNR)(NYSE:CNI) that has grown earnings per share at an average rate of 15.7% in that period. At the same time, it increased dividends per share at an average rate of 15.4%. In fact, the railroad has increased dividends for 19 years in a row.
If you care about a growing income and you want railroad exposure, there’s no question to buy Canadian National Railway before Canadian Pacific Railway.
Conservative Payout Ratio
The payout ratio is the percentage of earnings that are paid out to shareholders as dividends. For example, Southern Co has a payout ratio of around 75%. It means 75% of its earnings is paid out as dividends, and 25% is retained by the company to grow the business or pay down debt, etc.
Comparing a company’s payout ratio to its peers, you can tell whether it aligns with its peers or if it’s less conservative. For example, Duke Energy Corp (NYSE:DUK) and Dominion Resources, Inc. (NYSE:D) are peers of Southern Co, and they have payout ratios of around 70%, which is lower than Southern Co’s. So their dividends are more sustainable, based solely on payout ratio comparison.
So, other than comparing yields of peers, investors should also compare payout ratios. Generally, the lower the better because it implies a more conservative payout ratio, implying a safer dividend. Further, a lower payout ratio implies more room for expansion and higher dividends in the future.
If you’re looking for the safest dividends on the planet, start looking for wide moat stocks in stable sectors such as utilities and consumer staples.
Check if their past decade’s earnings have been in a growing trend, and how many years they had earnings growth within the decade. Further, check if the dividend stock has a history of increasing dividends. You can probably find a company’s dividend history on its corporate website.
Finally, compare the payout ratio of an interested dividend stock with its peers and also see if the payout ratio is in a declining trend. A lower payout ratio implies a safer dividend than a higher ratio, and the business is likely to grow its dividend faster.
If you like what you've just read, consider subscribing via the "Subscribe Here" form at the top right so that you will receive an email notification when I publish a new article.Disclosure: At the time of writing, I am long TSX:CNR and TSX:CP.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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