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.

(Photo Credit)

It is easy to be captivated with a top performer. Everyone loves a winner. During the 80′s and 90′s when Jack Welch ran General Electric (GE) the company was a well-oiled machine that routinely beat the streets expectation and the ever-increasing stock price reflected its performance. I once said that if I could only buy one stock for the rest of my life, it would be GE.

Then there’s the first-love dart – that first stock that you bought. For some reason there is often an emotional attachment for the first of anything. Some business owners frame the first dollar they earn, while some investors have a hard time letting go of the first stock they purchased, especially if the stock performed well for an extended period of time. For me it wasn’t the first stock I purchased (I can’t even remember what it was), but instead it was the first stock I purchased for its dividend that held a special place. That stock was a REIT, First Industrial Realty Trust Inc. (FR).

So what happened? Both stocks cut their dividends and I immediately sold them. To achieve our long-term investing goals we must remove emotion from the equation. It is a recipe for disaster when we make investing decisions based on a past relationship with a stock that is contrary to the current fact pattern.

That is not to say I am not fond of certain stocks. For example, I currently like or admire these dividend stocks:

Johnson & Johnson (JNJ) – Yield: 3.30% – Analysis
Johnson & Johnson engages in the manufacture and sale of various products in the health care field worldwide.

Nucor Corp. (NUE) – Yield: 3.10% – Analysis
Nucor Corporation is engaged in the manufacture and sale of steel and steel products. As the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas.

United Technologies Corp. (UTX) – Yield: 2.60% – Analysis
United Technologies Corp. is an aerospace-industrial conglomerate with a portfolio including Pratt & Whitney jet engines, Sikorsky helicopters, Otis elevators and Carrier air conditioners, among other products.

McDonald’s Corp. (MCD) – Yield: 3.60% – Analysis
McDonald’s Corporation is the largest fast-food restaurant company in the world. Its restaurants serve a varied, yet limited, value-priced menu in more than 100 countries around the world.

3M Co. (MMM) – Yield: 2.80% – Analysis
3M Co. is a diversified technology company with a presence in various businesses, including industrial & transportation, healthcare, display & graphics, consumer & office, safety, security & protection services, and electro and communications.

Not all of the above stocks are on my current buy list, but they are some of the ones that I keep a close eye on for good opportunities to add to my position.

Full Disclosure: Long JNJ, NUE, UTX, MCD, MMM. See a list of all my income holdings here.

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The “%” column is the percentage decrease between the “Sell Price” and “Recent Price”.  As you can see, each of the stocks continued to fall after it was sold. That adds substantive evidence that my sell after a dividend cut rule is the correct thing to do. With that said, I have begun to question if there were other indicators that should have led me to an earlier sale. Four of the above stocks have one other thing in common – they froze their dividend before cutting it. The table below shows those stocks and the price on the dividend freeze date (declaration date), along with the three stocks I currently hold with a frozen dividend:

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The “Freeze Price” is the closing price the first trading day after the dividend freeze was announced. The “Sell Price” for the first four (those that I have already sold), is the actual price I sold it for and for the three I still hold it is a recent price. Based on the above, it appears the prudent thing to do would be to sell a stock after it freezes its dividend. Like a dividend cut, an investment with a froze dividend is no longer aligned with my dividend portfolio’s goal of building an ever-increasing source of dividend income.

Care should be taken in considering that not only have the above stocks fell over the last year or so, but virtually every other stock has fell. So what appears to be hard and fast rules in this market, will need to be evaluated under different phases of the cycle. But for now, selling after a dividend cut or a dividend freeze appears to be a prudent rule to follow. However, I do not see the dividend freeze rule as stringent as the dividend cut rule. Each situation needs to be evaluated and sometimes an immediate sale is not warranted. Considering all this, I would phrase my dividend rule as such:

When an individual stock held as a dividend investment freezes its dividend, this is a strong sell indicator. The specific facts and circumstances should be immediately evaluated and continuously monitored until the stock is either sold or it increases its dividend.

If it is decided not to sell the stock, the pressure to sell should increase as time passes.  Another strong indicator to sell would be if the dividend freeze persists long enough to incur a flat dividend year-over-year. Dividend freezes need to be monitored closely. In many instances they are the first step to a dividend cut.

Full Disclosure: Long HD, MTB, RY