Topic: Dividend Stocks

How to pick the best income stocks

December 24, 2015|by Pat McKeough

The best income stocks have consistently paid dividends for many years.

Picking the best income stocks has become all the more important for income-seeking investors over the last few years. That’s mainly due to today’s low interest rates cutting bond yields and yields on other fixed-income investments.

But even if you don’t need current income from your portfolio, you still may want to invest in income stocks. When you pick the best income stocks, you are, for the most part, investing in safe and secure companies. That’s in large part because of the dividends that the best income stocks pay. 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 dividends or it doesn’t.

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However, it’s important to remember that not all income stocks are created equal. Here are two key guidelines we use to pick the best income stocks that we recommend in our investment services and newsletters, including The Successful Investor:

1. A reasonable dividend yield: You can identify income stocks by their high dividend yields (the percentage you get when you divide a company’s current yearly payment by its share price). For example, stocks with a dividend yield higher than, say, 3% would typically be attractive to an income-seeking investor.

However, it’s important to avoid judging a company based solely on its dividend yield. That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a company’s dividend yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield). That can be a sign of an imminent dividend cut.

2. Maintaining or increasing dividends: Apart from a high dividend yield, you should look for stocks that have a long history of paying (and raising) their dividends. For a true measure of stability, focus on those companies that have maintained or raised their dividends during the recent recession and stock-market downturn.

That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

Additional factors for finding the best income stocks to invest in

a) Financial factors:

Start your search by looking for companies that have a 5- to 10-year history of profits. Companies that make money regularly are safer than chronic or even occasional money losers. You’ll also want to look mostly for companies that have been paying dividends for at least 5 years—10 years is even better. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds. The last financial measure we like to see in a company is manageable debt. When bad times hit, debt-heavy companies often go broke first.

b) Safety factors:

Picking the best income stocks means picking stocks that have a degree of safety build into them. At TSI Network we look for companies that have industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Smaller firms, on the other hand, don’t have that ability.

The next safety factor we look at is geographical diversification. We like strong companies that operate Canada-wide, but we think multinational corporations are better. There’s extra risk in firms confined to one small geographical area. The last safety factor we consider is that the best income stocks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.

c) Survival/growth factors:

We feel that the best income stocks are the ones that are free from business cycles. Demand periodically dries up in “cyclical” businesses, such as resources and manufacturing. You can hold some of these stocks in your portfolio, but keep them to a reasonable part of a well-balanced portfolio.

We are also particularly keen on companies who have ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will in turn try their new products.
It may be hard to find companies that have all of these factors, but we feel the best income stocks have many of these factors.

Some of the best income stocks are in the Utilities and Financial sector

While we continue to recommend that you spread your investments out across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities), the proportion of your holdings you devote to each sector depends on your temperament and financial goals.

For example, if you’re an income investor, you may wish to place more emphasis on Utilities and Canadian banks. That’s because these firms generally pay high, secure dividends, and have long histories of raising their payments, even during downturns. However, you’ll still want to make sure your portfolio is well-diversified across all of the sectors.  

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.
You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Have you been successful researching the best income stocks to invest in? Has it been profitable for you? Share your experience with us in the comments. 

Note: This article was originally published in April 2010 and has been updated.