What You Need To Know To Setup A Portfolio

If you hold only stocks with double-digit yields, it can be very risky.

Diversify your dividend paying stocks across different yields and sectors. Industrials, technology, MLPs, REITs, healthcare, energy, consumer staples, etc. diversify among these groups and more.

You will constantly have some sectors outperforming the market and some underperforming.

Don’t just load up on stocks paying 10% dividends. You need to take into account risk and the growth of the dividend. The author would rather own a stock with a 4% yield that grows its dividend every year by 10%, than a stock with a 6% yield and a dividend growth of 4%.

How to Pick Dividend-paying Stocks:

The first thing you need to do is answer these questions:

1.What is your time frame?
2.What is the purpose of the portfolio, income or wealth creation?

If you need the money back in three years or less, don’t invest in stocks.

The compounding nature of the rising dividend really kicks into gear around year 8 or 9, the longer you can go without touching the principle, the better.

The key criteria you should factor are yield, degree of safety, and potential for dividend growth.

Don’t buy dividend stocks based on when the dividends are expected.

Remember that growth and safety of the dividend are more important than the yield.

Avoid the temptation of adding too many REITs and MLPs because of the high yields.

A stock with a yield of 10% should be a warning sign. If you are going to invest in a stock with that yield, look at it very carefully.

The first thing you should look at is the payout ratio. The payout ratio is the ratio of the dividends paid versus net income.

The payout ratio tells you whether the company has enough profits to maintain or grow the dividend. The lower the payout ratio, the more room there is to grow the dividend.

Avoid investing in companies with a payout ratio over 100%. That is often the scenario when you see a stock with a yield above 10%.

Calculate the payout ratio using free cash flow. It is a more accurate representation of whether a company will be able to pay its dividend than using earnings.

Cash flow is more difficult to manipulate than earnings and net income.

Generally, look for a payout ratio of 75% or less. If it is a utility, REIT, or MLP the payout ratio can be higher.

Dividend Growth Rate

The spreadsheet maintained at The Dividend Investing Resource Center has a column labeled DGR that shows the dividend growth rate of each company. The website Dividata offers the dividend history of most companies.

Companies will occasionally pay special dividends. Don’t include special dividends in any annual growth calculations.