Buy low, sell high. That’s the mantra of many investors in stocks. While it’s a nice, simple formula for profit at times, it’s incredibly tough to pull off during a bear market. If you’re looking to preserve wealth when stock prices are tumbling – a strategy financial advisers call defensive investment – purchase dividend stocks rather than growth stocks. While you probably won’t get rich on dividend checks, you’re much more likely to weather downturns in the market if you can identify qualities that make for a good dividend stock.
Companies use dividends to share extra cash with their investors, so it makes sense that companies who are more flush with cash or lacking short-term debt obligations, would be more likely to deliver a rewarding dividend. Investors track the ratio between the company’s liquid assets and redeemable securities using a measure reported as current ratio. Companies with a current ratio above 1.5 are most likely to spread their wealth with investors, according to Kelley Wright, the author of "Dividends Still Don't Lie: The Truth About Investing in Blue Chip Stocks and Winning in the Stock Market."
An ocean of liquid assets in a company’s holdings doesn’t necessarily mean it has plans to funnel that cash back to investors. Many companies choose to reinvest capital to promote growth or pay down long-term debt. A company’s payout ratio, or P/R as it’s reported on stock quotes, represents the percentage of its earnings that it funnels to dividends. Don’t be lured by high ratios alone, because a P/R of more than 50 percent from a company may be too high, cautions Ben Levisohn of Smart Money magazine. Companies with generally stable earnings, such as utilities and health care, may post higher P/Rs without indicating risk.
Any company can post an occasional dividend, and many make steady payments to their investors on a regular basis. The best bets for future dividends lie in companies with a history of dividends that continually increase with each quarter. These companies aren’t only maintaining their profitability but improving it and passing those increases on to shareholders. Companies that display a history of dividend growth for five or more years are the most solid dividend-stock purchases, according to Money Morning’s Don Miller.
Risks of Dividend Stocks
Don’t confuse dividend stocks with bonds. Companies that issue bonds typically pay investors a relatively low rate on their return. Because companies are legally required to pay bondholders as scheduled, they’re considered a low-risk investment. Companies aren’t required to pay dividends to shareholders. Historical dividends and current earnings may be strong indicators of a good dividend stock purchase, but they’re no guarantee that the company will continue to pay dividends. Downturns in the economy or a shift in priorities to reinvest earnings can lead once-profitable companies to cancel dividend payments.
- Comstock/Comstock/Getty Images