Published Mon, 09 Dec 2013 10:00 CET by DividendYields.orgGenerally, the aim here is to provide investors and stock pickers with insight into dividend stocks from around the world, and bring to attention companies that might otherwise go “under the radar” and escape attention. However, this article is a little different. Instead of offering stock tips and picks, it will take a step back and have a look at what makes up a great dividend stock. The aim is to provide the first steps in broadening the knowledge of what makes a good dividend stock beyond simply the dividend yield next to the stock ticker. The dividend yield is merely a starting point for further research.
Buy Businesses, not Dividend Yields
The first thing that can be gained from taking a step back is a step away from the devotion to simple percentage yield. This might seem like a counterintuitive action, but the logic suggests otherwise. First of all, it is known that a dividend is an earning that is not retained as profit within the company. So obviously there must be profits to distribute to have a dividend. Nothing new yet.
The best dividend stocks are those that can grow their dividends over time, otherwise the real value of what investors receive is eroded by inflation and other rising costs. For example, if Coca Cola held it's dividend at 1996 levels investors would be receiving a payment 130% less than 2013 levels. Therefore, a business which is increasing its dividend must also necessarily be increasing its profit, otherwise such payments would be unsustainable. Coca Cola clearly has been able to do this by retaining the number one position in terms of drinks, preserving it's secret formula, staving off intense marketing and competition from rivals (think Pepsi's multi-million dollar contract with Beyoncé) and diversifying its product range with new offerings such as Cherry and Vanilla Coke.
So the health of a business directly contributes to it's ability to first of all pay, and second of all, grow, it's dividend payouts to investors. So which companies hold this kind of power?
The factors that contribute to a successful company with the ability to grow it's profits sustainably make up a long list, ranging from industry competition, management skills, successful execution of investment risks, employee engagement and so on. But in terms of dividend payments, one of the most desirable qualities to have is to be boring. Doesn't sound right does it?
Look at it this way. If someone were to lose their job, they would be unlikely to walk into their local store and buy the latest iPad. That rules out Apple Inc. But what they would do would still buy food, gas and medicine: the bare essentials, and also the affordable luxuries. The listed examples are not hard to find. Even if you were unemployed, the car would still be filled up with gas, likely from Royal Dutch Shell, BP, ExxonMobil or Chevron. The grocery shopping would still need to be done, so Wal-Mart, Carrefour or Tesco would get a visit. There would still be the need for necessities like band-aids for when the kids scraped their knee (Johnson & Johnson and Proctor & Gamble) and medicine for when anyone in the family got sick (Glaxo Smith Kline, Roche, Novartis). Boring is beautiful in terms of dividend stocks because it means those businesses are indispensible. And indispensible means that the earnings are recurring and therefore so are the profits and the dividends.
The Search for Power
The final piece of the puzzle is to look for businesses with pricing power. For example, the listed pharmaceutical companies have limited pricing power because their competitors also seek to research, develop and market drugs that treat the same common (and therefore lucrative) ailments that all people have. The same thing is true of energy producers because they extract and sell the same basic product – resources in the form of natural gas or petroleum. The truly great dividend stocks are the companies that retain the ability to charge more for their products because the users are not happy to substitute it. The best example is also the simplest. Attempting to convince a Coke drinker that Pepsi is the same thing is likely to be a short conversation, because Coca Cola has been able to retain a loyal brand following, and therefore increase the prices that its charges it's customers. Wal-Mart has a similar advantage by lowering it's prices as much as it can because it drives the perception they are the lowest cost retailer in the market, and therefore attracts more customers than it's rivals, who cannot match it's cost cutting because they do not have the same amount of customers and earnings. Buying stocks with enduring pricing power is a sound tactic in ensuring that the dividend payments you receive are sustainable and likely to grow in the future.
None of the companies mentioned above are hidden gems or unheard of dividend stars. That is not the intention of this article. The intention is to get you thinking about what makes a great dividend paying business next time you come across a high-yielding stock tip, using companies that are well-known and easily recognised. Hopefully the lessons contained above will help to form a more rational and successful investing approach for all that choose to apply them.