Topic: Dividend Stocks

Finding the right dividend growth stocks can supercharge your returns

October 26, 2020|by Pat McKeough

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Dividend growth stocks are great additions to the portfolios of both new and experienced investors.

Investors generally look to growth stocks for capital gains and to more conservative stocks, like banks and utilities, for dividend income. Yet there are a number of dividend growth stocks that can also add to your investment income. Some even have dividend yields that are as high—or even higher—than yields on more established companies.

Dividend growth stocks are a welcome bonus—but focus on quality

As with conservative dividend-paying stocks, dividend growth stocks offer investors a measure of security. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.

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However, it’s important to avoid judging a company based on the fact that it pays a dividend. Nor should you be tempted solely by a high dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price).

That’s because high yield can sometimes be a danger sign rather than a bargain. For example, a dividend stock’s yield could be high simply because its share price has dropped sharply (since you use a company’s share price to calculate yield). That drop may signal investor anticipation of coming bad news.

As well, you should always remember that while growth stocks hold the potential for greater gains than conservative selections, they typically expose you to a higher level of risk—even if they are dividend-paying stocks.

That’s why we look beyond dividend yield when making investment recommendations, and look for dividend stocks that have established a business and have at least some history of building revenue and cash flow.

What are some financial factors you should look for in dividend growth stocks?

As we mentioned above, dividend history is very important to a dividend growth stocks. Ideally, you should look for dividend growth stocks that have been paying dividends for 5 or more years. As a general rule, companies that make money regularly are safer than chronic or even occasional money losers. Companies can fake earnings, but dividends are cash outlays.  If you only buy dividend-paying value stock picks, you’ll avoid most frauds.

What is the dividend growths stock’s debt load like? Would it have a hard time recovering from an economic downturn? The more manageable the debt, the better. When bad times hit, debt-heavy companies often go broke first. Especially ones that also keep trying to allocate part of their cash flow to paying dividends

What are their growth prospects like?

By definition, growth stocks are companies that have above-average growth prospects. They are firms whose earnings growth has been above the market average, and is likely to remain above average. Typically they re-invest their cash flow in the business, to promote their growth. Top-quality dividend growth stocks have the special ability to reinvest earnings and pay a dividend.

Although dividend growth stocks can be highly volatile, they can often make good long-term investments. They may be well-known stars or quiet gems, but they do share one common attribute—they are growing at a higher-than-average rate within their industry, or within the market as a whole, for years or decades.

Before investing in dividend growth stocks, you need to confirm its growth prospects. You can start by examining their balance sheet. Where have they spent their money? On productive research and development? What parts of the company are under-performing?

Is the dividend growth stock in question a multinational company or are they geographically locked to a certain area? There is extra risk involved with firms confined to one geographical area.

Does your dividend growth stock candidate have any hidden assets?

Hidden assets can be the tipping point for investing in dividend growth stocks. Hidden assets can come in the form of real estate, a loyal customer base, or a loyal following. For instance, when a company buys real estate, the purchase price goes on its balance sheet as the historical value of the asset. Over a period of years or decades, the market value of that real estate may climb substantially. But the purchase price remains unchanged on the balance sheet.

You have to look closely to spot this hidden value. At times, the hidden value in a company’s real estate can come to exceed the market value of its stock. This hidden value may only become apparent to investors when the company upgrades the use of the real estate. For example, a merchandiser might repurpose a parking lot to build a shopping mall with a residential condo tower on higher floors, and a parking garage down below.

Understanding and seeking out hidden assets while you’re evaluating a dividend growth stock can add enormously to your profits over the course of your investing career. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Hidden assets can also cut your risk. Stocks with hidden assets are likely to hold up better than those whose assets are easier to spot, since they are the last stocks that experienced, successful investors sell. When times are good, on the other hand, stocks with hidden assets tend to do better than average.

Finding a dividend paying growth stock can be a great way to boost the long-term returns of your investment portfolio.

Have you ever invested in a dividend growth stock? Was it profitable? Share your experience with us in the comments.