Those that have read this space for any period of time are well aware of my enthusiasm for using dividend growth stocks as a vehicle for building long-term wealth and income. However, with that said, a successful investor must do more that just buy stocks that pay a growing dividend, or more that focusing on a single metric such as dividend yield. Not all dividend stocks are created equal – there is a discipline to selecting good dividend growth stocks.
Understand Your Goal
What is your portfolio trying to accomplish? As odd is it may seem, many investors never define this and their overall goal. Are you buying stocks like First Industrial Realty Trust, Inc (FR) with a 22% yield, Capstead Mortgage Corporation (CMO) with a 17% yield, Annaly Capital Management, Inc. (NLY) with a 16% yield or Apollo Investment Corp. (AINV) with a 12% yield? If your goal is short-term income these might work, and then again they might not.
Before buying buying any stock you should write down your investing goal and determine if purchasing that stock will bring you closer to your goal or take you further away. My goal is to generate an ever-increasing income stream from dividends. Thus, I will sacrifice some current income in favor of future growth and income stability.
Understand and Measure the Risk
No stock is 100% safe. Each stock has its own set of risks that need to be considered. The stocks listed above are considered high risk. In exchange for above average current income, you may encounter above average dividend cuts and/or loss of capital.
Gauging the relative risk of one stock compared to another is important when deciding which stock to buy or how much to weight a stock within your portfolio. I prefer lower risk stocks such as Johnson & Johnson (JNJ) [Analysis], Procter & Gamble Co. (PG) [Analysis]and Wal-Mart Stores, Inc. (WMT) [Analysis].
A Disciplined Approach
For me and my income portfolio, I have have chosen to follow a conservative and disciplined approach. This means I will seek out dividend stocks with a proven track record and good future prospects. These stocks will have a long history (10 or more years) of consecutive dividend increases, low debt, low free cash flow payout and excellent other dividend metrics. In addition, I will follow time proven valuation techniques to select an entry point that will provide a good value.
Stay The Coarse
There is always a temptation to stray from a disciplined approach of selecting good dividend stocks. Often I receive questions like, ‘AT&T Inc. (T) is making a fortune off the iPhone, why aren’t you buying it?’ or ‘Kraft Foods Inc. (K) is a great consumer staple, why aren’t you buying it?’ The short answer is that neither currently can pass the entry exam to gain access to my income portfolio.
It is easy to become caught up with the current hot stock that everyone loves. The key to success is to buy before everyone else falls in love with it. Selecting good dividend growth stocks is not difficult, being disciplined enough to do it is difficult for many investors.
Full Disclosure: Long JNJ, PG, WMT. See a list of all my income holdings here.