How to Choose Dividend Stocks

Dividend stocks are the bedrock for any long-term portfolio. That's not news. If you've spent 30 minutes on any financial media website or Investing 101 primer, someone somewhere has assuredly told you that a portion of your investments should be spent collecting stock dividends.

The rub is this: In a market with literally thousands of stocks paying out dividends ... well, where in the heck do you even begin?

Many market pros suggest looking for any number of traits, but all of them boil down to a search for quality investments that provide at least some of their returns in the form of cold, hard cash.

Charles Sizemore, a portfolio manager on Covestor and chief investment officer at Sizemore Capital Management, a registered investment advisor in Dallas, points out four things investors should do when seeking out stock dividends:

1. Look for companies that are recession-resistant and have stable cash flows.

2. Look for consistent dividend growth.

3. Look for a high yield, but not excessively high.

4. Watch the payout ratio.

Let's dig into each of these points.

Quality counts. Interestingly enough, the first point demands that people researching dividend stocks not focus on the dividend -- not completely, at least. You're looking for a solid business, because that ultimately will fuel a consistent, healthy dividend.

"You are still buying the stock of a company, and so you want to make sure you are comfortable with the company's business and management team, along with the company's balance sheet and overall financial condition," says Jim Wright, a portfolio manager on Covestor and chief investment officer at Harvest Financial Partners, a registered investment advisor in Paoli, Pennsylvania.

So, what signs of quality are you looking for? It depends on who you ask.

Tony Weeresinghe, founder of the trading network Ustocktrade, says beginning investors should look for companies that grow net profits significantly -- not just revenues -- because stock dividends are paid out of a company's earnings.

Sizemore says to look at the dividend history. "Did they cut their dividend during the last recession?" he asks. "As a rule of thumb, I say that a company that survived 2008 with its dividend intact is likely to keep that dividend intact through the next crisis, too."

Certain sectors and industries are more likely to foster healthy dividend stocks than others. Yale Bock, a portfolio manager on Covestor and president of Y H & C Investments in Las Vegas, says investors should look for stable industries such as telecom, health care, defense and groceries.

Keep it growing. While it's far from a bad thing for a dividend stock to maintain its payout over a long period, many professionals agree that dividend growth is a much better sign for any company paying dividends.

Dividend-focused investment site Simply Safe Dividends points out that "a growing dividend is often a sign of durability, stability and confidence in the underlying business."

Besides, you want your dividend to keep up with inflation, don't you? "You want companies that raise their dividends every year, or at least close to every year," Sizemore says. "Otherwise your stock is essentially a risky bond and nothing more."

Simply Safe Dividends offers up the perfect place to begin looking for dividend growth -- the S&P 500 Dividend Aristocrats index, which includes companies that are in the Standard & Poor's 500 index that have increased dividends annually for at least 25 consecutive years.

How high? Generally speaking, most professionals advise against dividend yields that are "too high."

Investors want to look for "a company whose dividend yield is not too high compared to other companies in its industry," says CJ Brott, a portfolio manager on Covestor and chairman of Capital Ideas, a registered investment adviser in Dallas. "Extremely high yields usually reflect a lack of confidence in a company's ability to continue paying a dividend."

Sizemore agrees, saying that "extremely high-yielding companies often are in distress and at risk of cutting their dividends. However, there are exceptions."

A good example of such an exception is AT&T (ticker: T), which yields more than 5 percent -- what would be considered a dangerously high yield in a number of industries, but is plenty sustainable, thanks to the cash-flow-rich nature of telecom.

"And certain sectors, such as business development companies and real estate investment trusts, tend to have much larger payouts than regular, mainstream stocks," Sizemore says. Take the SPDR Dow Jones REIT ETF (RWR) -- an exchange-traded fund holding REITs such as Simon Property Group (SPG) and Public Storage (PSA) -- which yields a healthy 4.6 percent.

Really, though, what constitutes a good yield is relative. "In today's low interest-rate environment and with an S&P 500 yield of about 2.2 percent, stocks with yields in the 3 to 7 percent range can look very appealing," Wright says. "Additionally, a company with a lower yield, like 1 or 2 percent, may have the capacity to grow the dividend very rapidly."

But the overall idea is that while you want sizable stock dividends, you also want to make sure they won't just disappear. Which brings us to the fourth point.

Payout ratios matter. One of the best signs of dividend stability is the payout ratio.

"The payout ratio is simply the dividend (in dollar terms) divided by the company's earnings per share," Wright says. "For example, company X pays a dividend $1 per share and they will be earning $4 per share, the payout ratio is 25 percent."

Lower payout ratios typically mean the dividend is more manageable, with plenty of room for future dividend growth.

"We would prefer to purchase a company that has a very well-covered dividend and, therefore, a payout ratio of less than 50 or 60 percent," Wright says.

You also want to make sure the company isn't robbing Peter to pay Paul.

"Stay away from highly leveraged companies, or those which borrow heavily to pay dividends," Bock says. "Generally, you want a business paying dividends out of their profits. Large oil companies are borrowing to support dividends, but they have been profitable for decades and have large pension constituents."

Though, not all large oil companies are handling the low-oil environment well. ConocoPhillips (COP) offers the perfect example of investor sentiment toward dividend stocks that aren't perceived as reliable anymore.

"There are oil companies that issue dividends, but right now, oil prices are creating problems for these companies," says Kevin Guth, partner and managing director at Snowden Capital Advisors in New York. "This is when it's important to watch these companies closely. For example, ConocoPhillips just cut its dividend, even though they paid it for many years. In that case we would want a company like that out of our portfolio and bring something in more consistent and stable right now."