Best Strategies for Finding Top Dividend Stocks-2020-03-05
By: Ned Piplovic,
Top dividend stocks are the easiest way for income-seeking investors to generate the cash flow that they need from their investment portfolio.
However, all dividend stocks are not created equal even though dividend investing seems fairly simple on the surface. Investors should seek equities with the highest dividend yields in order to identify the top dividend stocks for their investment portfolio. Unfortunately, like everything to do with investing, dividend investing is slightly more complicated than that.
Dividend-paying equities differ in their approach to distributions in terms of payout level, frequency and other aspects. Furthermore, depending on each investor’s specific goals and time horizon outlook, each investment portfolio can have different dividend income requirements. Therefore, investors must understand their cash flow needs to be able to identify the top dividend stocks for meeting their specific investment strategy.
Because of varied strategies and goals, various equities will obtain the label of top dividend stocks for different portfolio requirements. Furthermore, even within the same portfolio, the identity of the top dividend stocks will change with passage of time. For younger investors, especially those who currently have a primary source of monthly income, the top dividend stocks might be equities with slightly lower distributions but higher total returns for building the portfolio’s equity base. Additionally, younger investors with a long-term time horizon outlook might consider equities with high payout ratios even though they can be riskier. Also, these investors might deem semi-annual or even annual dividend payouts acceptable.
Alternatively, as investors near the end of their working careers, they might shift their positions into equities with higher yields but lower total returns to generate the necessary cash income flow to cover their ongoing expenses in retirement. Furthermore, to cover these expenses, these older investors might prefer equities with monthly, or at least quarterly, dividend distributions.
Therefore, investors should understand the different distribution options available to identify the equities that offer the best potential to be the top dividend stocks for their specific portfolio needs. With the rise of computer modeling and algorithms, equity analysis has become significantly more complex for the average investor. However, understanding just a few basic concepts in dividend investing can be sufficient enough to create an investment portfolio that will generate the desired stream of dividend income.
With many nuances to dividend investing, a single article can not be the ultimate and complete resource on dividends. However, with the basic information included in this article, income investors can start to build or expand their knowledge to be able to identify the top dividend stocks for their unique portfolio requirements.
Top Dividend Stocks Offer Potent Payouts
Dividends are simply distributions used to transfer a portion of an equity’s earnings or assets to the stakeholders. While the term dividends generally covers all types of payouts, that specific designation applies explicitly to earnings payouts by specific equity types, such as C Corporations. Alternatively, different types of equities — such as S Corporations, limited liability corporations (LLCs), partnerships, estates, trusts, etc. –technically pay distributions.
While generally interchangeable, the terminology distinction generally helps distinguish the types of payouts for taxation purposes. Equities generally pay dividends from their earnings. Those payouts do not figure into the original cost basis of buying the stock. Alternatively, distributions, which are generally dispersals of equity, figure into an investor’s cost basis for determining one’s tax liability. However, because most concepts apply to both types of payouts, the term dividend will represent both dividends and distributions for the remainder of this text.
Top Dividend Stocks: Do Dividends Enhance Equity Valuation?
Like with most investing topics, the answer to this particular question depends on many factors and is a source of frequent and intense debates. One side of the debate disregards the contribution and impact of dividend distributions on the overall value of an equity and their benefit to shareholders. This side of the debate bases its argument on the Modigliani-Miller Theorem.
Developed by economists Franco Modigliani and Merton Miller in the 1950s, the theorem argues that dividend distributions are wasted opportunities and offer no long-term advantages for capital gains in perfect market conditions. According to Modigliani and Miller, instead of distributing earnings to shareholders as dividends, a company can deliver higher total returns by financing new investment opportunities with any extra corporate earnings.
The Modigliani-Miller Theorem does stipulate that companies should only consider distributing dividends as a last resort and only if there are no alternative investment opportunities that could generate additional returns. While certainly offering a persuasive argument, the Modigliani-Miller Theorem requires perfect market conditions to be effective, which rarely exist. Perfect market conditions might occur occasionally and for brief intervals of time, but very rarely last for extended periods.
The Opposing View
While unable to prove a definite causal relationship between dividend payouts and outsized long-term returns, the other side of this argument does have historical results on its side. Analysis of historical performances has indicated that dividend-paying equities outperform their non-dividend counterparts over extended time horizons.
The dividend payouts might just be a byproduct of a company’s operational and financial performance. A company that generates large earnings has a sufficient cash flow and can afford to distribute a portion of those earnings as dividends.
However, investors generally see dividend-paying equities, especially equities with long-term distributions and rising payouts, as safe places for reliable capital gains and income distributions over the long term. The dividend payouts encourage investor loyalty. This loyalty allows companies to plan and execute growth strategies over extended periods, with a reduced fear that investors will flee at the slightest sign of trouble or an occasional quarterly earnings miss. Also, this shareholder loyalty and the historical record of long-term performance allows these dividend paying companies to more easily raise cash when needed than companies without dividends.
Top Dividend Stocks: Historical Performance
In 2019, Hartford Funds conducted a study that compared the total returns of S&P 500 stocks between 1960 and 2018. According to the study, the S&P 500 Index rose more than 43-fold over that time frame. While that represents a substantial return on investment, including reinvested dividends in the calculation increases the total return over the same period from 43-fold to 246-fold. The graph below from the Hartford Funds study illustrate that for every $1 of direct capital gains, reinvested dividends generated $5.70 in additional returns.
Graph Source: The Power of Dividends, Hartford Funds, January 2019
A separate study conducted by Ned Davis Research has indicated that top dividend stocks with rising dividend payouts have outperformed all other types of equities over extended time horizons. This study classified all S&P 500 equities into five categories based on their dividend status and compared their returns to the total return of the overall index between 1972 and 2018.
Equities with no dividends tripled in value over that time period. However, that growth was less than 12% of the overall S&P 500 Index, which advanced 27-fold during the tested time frame. Also, equities that chose to or were forced to cut their dividend distributions advanced less than 70%, which is not even 2.5% of the Index’s overall return.
Equities with steady dividend distributions advanced 52-fold, which is nearly twice the overall index’s return over the same period. However, the best performing equities delivered long streaks of rising annual distributions. Between 1972 and 2018, dividend-rising equities advanced 75-fold, which is nearly triple the average index gain and almost 2,400% better than equities without any dividend payouts. Therefore, investors should always seek equities with steady streaks of rising dividends when searching for the top dividend stocks.
Top Dividend Stocks: Other Considerations
The most common, and generally most advantageous, type of distributions are cash dividends. Because of their easy management and simple delivery method, cash is the preferred way of dividend distribution.
While not distributed as frequently as cash payouts, equities occasionally dispense in-kind dividends. The in-kind distributions generally come in the form of stock dividends. Additional forms of in-kind dividends can be bonds of the company that is distributing dividends, bonds of a different corporation, government bonds, accounts receivables, promissory notes, etc.
The main advantage of stock dividends is that the Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, these distributions do not carry any tax liability in the year in which the dividend is distributed to shareholders. Investors incur tax liability only when they sell the shares, and even then, the profits are taxed at the capital gains rates, which are generally lower than rates on ordinary income.
While stock dividends generally have the advantage of deferred taxation at the lower capital gains, some cash distributions — called qualified dividends — also are eligible for taxation at the lower capital gains rates. Generally, only companies established in the United States are eligible to issue qualified dividends. This type of dividend payouts has the same capital gains tax liability as stocks and stock dividends. In addition to being domiciled in the United States, equities must meet a whole set of strict IRS rules and requirements to attain qualified dividend eligibility.
Top Dividend Stocks: Payout Frequency
As indicated earlier, some investors will take the payout frequency into consideration to find the top dividend stock for their own portfolio. While publicly-traded equities must declare and document their distributions, there are no legal requirements that determine dividend distribution frequencies. Therefore, most equities use the dividend distribution schedule that best aligns with the company’s business cycle or their financial results release timetable.
Most equities in North and South America distribute their dividends on a quarterly basis and some offer monthly payouts. As already mentioned, the monthly income distribution timetable aligns better with the payment schedule of investors who rely on dividend distributions to cover their ongoing monthly expenses. However, even investors who reinvest their dividends back into the equity immediately can benefit from monthly payouts.
Without any change in the total annual payout amount, investors can gain additional returns on their investments by taking advantage of the compounding effect. By receiving the total annual dividend payout in monthly installments — and reinvesting immediately — investors can achieve a substantial boost in their annual gains. With a 6% annual rate of return, reinvesting the monthly dividend payouts will yield additional returns of 6.23% in just the first year compared to the quarterly distribution schedule. By the end of the second year, the additional gains will exceed 13% and reach 50% in just six years. As with all compounding, the longer the time horizon, the higher the returns. The strategy of reinvesting monthly payouts will double one’s total in just a decade and be five-fold higher than the returns from reinvested quarterly payouts by the end of the second decade.
Identifying Top Dividend Stocks
Regardless of any specific portfolio needs, investors must be able to identify the top dividend stocks for their specific investment strategy. Equity analysis became quite complex with the use of computer analysis and the introduction of artificial intelligence modeling. However, even with just a few basic performance metrics, investors can relatively easily narrow their selection of top dividend stocks from the tens of thousands of available equities to just a handful of potential investment options.
Assessing Dividend Yield
The dividend yield is the most frequently used dividend metric. A simple ratio of the equity’s total annual dividend distribution amount and the equity’s current share price, the dividend yield is easy to calculate and is readily available from most sources of information on investment markets. While higher yields are obviously better, investors must make sure that the high yield stems from rising dividend payouts and not declining share prices.
A sudden share price drop will result in a yield spike, which can make the equity appear more desirable than it actually is. Also, a share price spike will push the yield lower. Therefore, investors must use the dividend yield in conjunction with other metrics to discover the top dividend stocks for their portfolio. The total return over the trailing 12-month period is an easy metric to use in these situations. As long as the one-year total returns exceed the yield, the equity has managed to provide at least minimal asset appreciation to accompany the dividend distributions.
Dividend Payout Ratio
Another simple metric is the Dividend Payout Ratio. This ratio indicates the share of net earnings that an equity distributes as dividend income. Investors generally consider a payout ratio in the 30% to 50% range to be optimal. Dividend payout ratios below 30% indicate that the share of earnings which is distributed as dividends is not substantial enough to make the equity desirable to income investors. Alternatively, equities might not be able to sustain dividend payouts that exceed half of their net income and could end up announcing dividend cuts or even the outright elimination of dividend distributions. However, certain types of companies such as real estate investment trusts (REITs), for instance, pay higher payout ratios by design. Some equities must distribute at least 90% of their earnings as dividends to achieve and maintain special IRS requirements that exempts them from paying corporate taxes.
The dividend yield and the dividend payout ratio are merely two of the most frequently-used dividend metrics. Additionally, investors should pay attention to the record of annual dividend hikes since equities with long streaks of rising dividends tend to outperform over an extended time horizon.
While investors have many aspects of dividends and metrics to consider, top equity stocks will generally pay rising qualified cash dividends with yields in excess of 3% and payout ratios in the 30% to 50% range. Unfortunately, equities that offer all these characteristics at the same time are quite rare. Therefore, investors must balance these characteristics by diversifying their portfolio with individual equities that offer some of these desirable attributes in order to move towards achieving each individual portfolio’s goals and strategies over the long term.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.