If you’re looking for one of the best sources of inspiration for understanding how to invest in dividend stocks, you need look no further than Warren Buffett.
As one of the most high-profile American stock market investors around, Warren knows exactly what criteria should be considered when determining which companies offer the best dividend paying stocks.
The six features outlined below describe the most important factors to be considered when picking dividend stocks with investment potential, and they might just give you the edge you need to consistently build your wealth, like Warren Buffett has.
1. Investigate the Company’s Dividend History
The value of every dividend stock lies in a company’s ability to generate earnings both today and tomorrow, and one of the best ways to determine that company’s potential for continuing to generate future earnings is by investigating its dividend history.
Companies that pay dividends do so from the profits they earn through conducting their regular business activities.
If a business has a track record of consistently increasing both its earnings and its dividend payments over a period of at least five years, it probably offers a good chance of continuing to perform well into the future. This is particularly true if its history has included periods of recession or other market downturns.
Warren Buffett makes a habit of investing in companies with long and positive histories, such as Coca-Cola for example, since these are the businesses that have demonstrated an ability to compete, adapt and grow within their ever-changing industries.
The longer a business has been around, the more confident an investor can be about expecting it to continue to generate positive returns for shareholders.
2. Look for Fundamentally Strong Businesses
Beyond earnings and profits, a company’s sales revenues and cash flow should be examined, since they can serve as important indicators of how successful and effective its business operations really are.
Sometimes earnings reports can make it seem like profits are higher than they are, simply because a company has cut its expenses in a given year rather than increased its sales. This can be very misleading since it doesn’t necessarily mean that the business is performing any better, or is selling any more of its goods or services.
At the same time, you should investigate a company’s cash flow situation. Operational cash flow represents the amount of money that’s available to fund a company’s operations, and any business with a negative cash flow will only be able to continue operating for so long.
You should never assume that a company has sufficient operating funds just because its sales revenues are increasing.
If a business is inexperienced in handling its debt load, or is inefficient in collecting the monies it’s owed, it could find itself in trouble regardless of how many sales it’s making.
Remember that Warren Buffett only invests in fundamentally strong and high quality companies that have the lowest risk of collapsing or becoming obsolete.
3. Look for Companies with Strong Competitive Advantages
When it comes to evaluating stocks that pay dividends, it’s important to recognize that every business has its competitors.
Even if its track record indicates that a company’s been able to outperform its competitors strongly enough in the past to generate profits over the long-term, how can you know if it will be able to maintain its competitive advantage in the years to come?
Naturally, no investor, not even Warren Buffett, can predict the future with absolute certainty.
But if you consider companies that have a sustainable competitive advantage, you will increase your chances of picking dividend stocks with the best potential for providing you with income well into the future.
What makes a competitive edge sustainable?
Some businesses establish such high profile reputations as leaders within their industries, that it becomes very difficult for other companies, old or new, to compete with them. Competitors may manage to go head-to-head with more successful businesses temporarily – by selling their products or services for less – but undercutting prices is not a sustainable marketing practice without the financial resources to support it. At other times, a company may grow so quickly that it doesn’t get the chance to develop a strong enough financial framework to support its expansion. It, too, will often end up succumbing to the loss of its competitive edge.
When Warren Buffett invests in companies that pay dividends, he seeks out businesses that demonstrate a strong competitive advantage that is also durable.
Whether it’s a widely recognized brand name, a solid financial foundation that increases buying power, or a unique product patent, these types of competitive advantages allow well-managed companies to keep churning out dividends over the long run.
4. Look for Companies that have Future Growth Potential
It’s important that you consider whether the product or service a company offers will continue to be in demand in the future.
Regardless of a company’s competitive advantage over other businesses within the same industry, there’s no guarantee that the industry as a whole might not experience a decline in years to come.
For a business to succeed over the long run, it must continuously adapt to changes within its market sector or, in the case of Warren Buffett’s top holdings, must already be part of an industry that changes very slowly to begin with, such as the banking industry.
Beyond this, you should check to see if the companies you’re considering investing in are offering goods or services that are geared toward segments of the population that are growing, in both numbers and in individual earnings potential.
If there aren’t enough people with enough money to buy what a company sells, that company is going to have trouble generating profits. And no profits, means no dividends.
Lastly, the dividend-paying companies you pick should have a future growth potential you can readily identify, whether it’s in the form of plans for a new product line, bigger production facilities, or an expansion into new markets.
5. Look for Undervalued Stocks
Undervalued stocks are those offered by high-quality businesses that have become unpopular with investors, and that are now trading at or below what is considered fair market value.
Sometimes companies experience one-time events that cause their stock prices to drop over the short-term. These events often take the form of high profile news reports or scandals, such as an oil spill that affects the reputation of a petroleum company, for example. In time, the negative repercussions caused by these events blow over, and stock prices usually rebound if the business involved is fundamentally strong, and able to continue its operations as usual.
In many cases, unpopular stocks offer attractively low price-to-earnings ratios, and often end up priced well below the value of a company’s assets.
Warren Buffett’s example tells us that we should look for a combination of both quality and value in order to benefit from the best long-term returns, since an “unloved”, but quality, company has a good chance of boosting its stock price back up to its intrinsic value over time.
6. Invest for the Long Run
In all the factors we’ve discussed for picking the best dividend paying stocks, holding your investments for the long-term plays a key role. Investing for the long run, whether it’s years or even decades, gives your stocks the opportunity to live up to their full potential in terms of growth and performance.
This can translate into several advantages for you, including:
- Compounded returns
- Deferred taxes
- Low turnover costs
Compounding your returns, or putting your earnings to work by reinvesting them and having them generate additional earnings, can only happen over time.
When you use your dividends to purchase additional shares of stock on a regular basis, your earnings will continue to grow exponentially. And if you take advantage of a DRIP (dividend reinvestment plan), you can set up this compounding tool to function automatically, with no extra work on your part.
Buying and holding your dividend stocks also means that you can benefit from the returns they offer without having to pay capital gains tax.
When you sell a stock that has gone up in price since you bought it, you must pay a special tax on the amount gained. But if you hold onto your income-generating stocks for the long run, you can continue to benefit from compounding returns that are unaffected by any increase in the stock’s price. This is the investment approach that Warren Buffett is best known for.
And finally, when you buy or sell a stock in your portfolio, you often become subject to transaction costs such as commission charges or brokerage fees. These types of turnover costs can add up over time, taking money out of your pocket and affecting your overall return on investment.
Holding your dividend stocks for the long-term not only helps to keep investment costs down, the fees you save can provide you with more available money to invest.
The Bottom Line
The bottom line when it comes to picking dividend stocks like Warren Buffett is to keep things simple.
His proven strategy of choosing a few, fundamentally strong and high-quality companies that demonstrate both a solid performance history, and a promising future potential, has helped to make him the investing giant he is today.
And it’s sure to help you, as well.