Every investor should have dividend stocks as part of a diversified investment portfolio. After all, not only are dividends a form of income, but a stock's dividend-yield analysis represents another valuation metric for your investor's toolkit.
The dividend companies that I personally prefer are those that I call "dividend dynamos" -- companies that continue to increase their dividends year in and year out. The Nasdaq U.S. Broad Dividend Achievers Index lists many of these, while the PowerShares Dividend Achievers ETF (PFM) aims to replicate the Dividend Achievers Index's performance.
To make it into both the index and the ETF, a company must list U.S.-accepted securities with at least 10 consecutive years of increasing annual regular dividend payments. Stocks get booted out if they suspend or cut their dividend by 50% or more. That might seem harsh, but know one of the key mantras of investing is to stick to your pre-determined rules.
When we look into the ETF's current components, we see a number of "dividend-aristocrat" companies. That includes not only one of my favorite names -- spicemaker McCormick & Co. (MKC) -- but also PepsiCo (PEP) , Exxon Mobil (XOM) , Johnson & Johnson (JNJ) and more than 250 other long-time dividend payers. This tells us that whether you buy this ETF or stick to individual stocks, there's a fertile list of dividend aristocrats to choose from.
When to Buy a Dividend Aristocrat
Of course, an important question is: "When should I buy a dividend aristocrat?" The glib answer is to "buy low and sell high," but the reality is a little trickier than that.
Answering that question brings us back to the dividend-yield analysis that I mentioned above. That's a great tool for helping to determine if a dividend stock is cheap or expensive.
Based on historical dividend yields, we can determine (and even do some "sandbox forecasting") of what upside investors might see if one of these companies once again boosts its dividend.
Historically, we've tended to see dividend aristocrats' stock prices rise by a "step- function" higher as they've increased their dividends. For example, McCormick & Co. has steadily increased its annual dividend over the past 28 years, which has represented a key factor in the stock's long-term upward trend.
Why is that? Simple -- because companies pay dividends (or at least the kind we want to own) out of their cash flow, so the firm's underlying business must generally be solid if management has cash to boost the dividend.
In McCormick's case, it's been able to grow its dividend for more than 50 years thanks in part to the noncyclical nature of its business. Management has also had a good strategy of making "nip-and-tuck" acquisitions that will grow its offerings even as the company wrings out costs.
How to Assess Cash Flow
So, it's important for investors to understand how a given company pays for its dividends. I prefer ones who do so out of current cash flow -- that is, the operating business.
By contrast, you sometime see companies float debt that management uses to increase dividends and pay for share-repurchase programs. I'm not a big fan of that strategy. To me, it's little more than the financial equivalent of Spanx -- aimed to look appealing even though the underlying reality might not be as favorable as you think.
I tend to avoid such companies as a general rule, and that means combing over balance sheets and cash-flow statements to see where the money for dividends is coming from. If we see a change in how a company pays for its dividends, that could be a signal that something is amiss. That could be a signal that the company might be about to cut its dividend -- which tends to be major blow to the firm's share price.
This article was originally sent to subscribers of TheStreet's Income Seeker, a product presenting the world of opportunities in fixed income and dividend stocks. Click here to learn more about Income Seeker and to receive articles like this from Robert Powell, Peter Tchir and others.