Check out these three dividend investing strategies for safety and return.
I love dividend stocks, but with more than 7,000 companies paying a dividend, finding the best investment for a portfolio can be challenging. To narrow the field, I like to invest across themes that help me reach my financial goals.
Themes could be around trends like the aging population, healthcare stocks, or the need for safety. Picking dividend stocks around a theme helps reduce risk around a particular company and emphasizes larger forces rather than finding a hot stock.
Check out the three themes below to help you pick great dividend stocks for your portfolio.
Utilities and Consumer Staples for Yield and Safety
One of the first things investors look for in dividend stocks is a consistent income and safety from the ups and downs of the regular market cycle. Even if dividend stocks did not consistently outperform their non-dividend peers, you get the constant protection they provide when your neighbor is tearing his hair out because his momentum stocks tumbled.
There are a couple of reasons for this. First, dividend stocks tend to be in more mature industries. The steady cash stream allows the company to start giving back to investors. Dividends also offer a positive return even when stock prices fall. That cash payment is always going to be positive.
Few sectors provide the safety and yield of utilities and consumer staples. In mature or semi-regulated industries, these companies have non-cyclical cash flow that increases steadily in the worst of times and the best.
Stocks in the utility sector offer one of the highest dividend yields as a group, around 3.6% for the Select Sector SPDR Utilities Fund (XLU). The industry can be further separated into regulated and unregulated services or through different segments like water, gas, electric, or alternative energy. Unregulated companies operate in a relatively limited competitive environment with allowable rate increases and steady profits.
Companies in the consumer staples sector may not pay a yield as high as those in the utility sector, but growth is usually slightly more elevated. The Consumer Staples Select Sector (XLP) pays an average yield of 2.7% but still finds growth opportunities in emerging markets, and share prices should add to total returns. The companies sell products everyone needs daily and have built immense brand loyalty over decades. There is little threat of new competitors coming into the space because of the vast economies of scale the companies have made through global production and distribution.
Investing in utilities and consumer staples is not without risk. For the safety of stable growth, you often give up some return, so do not expect the share prices to shoot higher in any given year. Since utilities cannot increase their rates quickly, their shares react like bonds when interest rates rise. That means when interest rates increase, other investments may be more attractive, and the shares lose their value. Companies of consumer staples can raise their prices a little faster, but competition usually limits the ability, and neither sector is a good hedge against inflation.
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The New Breed of Dividend Tech Stocks
Investing only in the safest dividend stocks and sectors means you may be giving up growth that will help meet your financial goals.
The new breed of technology companies that pay dividends for portfolio growth is a great addition. Some of the more extensive tech dividend stocks like Microsoft (MSFT) produce yields higher than the general market. These companies still see relatively strong sales growth in developed markets and faster growth opportunities in emerging markets worldwide. Often, these companies also buy growth through acquisitions of new technologies or patents.
Many new breeds of tech dividend-payers don’t generally pay a high yield, so you must sacrifice some current income for growth. Companies in the sector face more competition than in sectors like utilities or consumer staples, so there is no guarantee of higher share prices. I like to focus on an established management team that has historically proven it can execute competitive goals and keep the company relevant.
Real Asset Dividend Stocks for Inflation Protection
Even though inflation has dropped to historical lows, it can eat away your income over a more extended period. That cash flow you collect now will only buy two-thirds of the amount of stuff in 20 years, even at a low 2% rate of annual inflation.
And low inflation hasn’t been the norm. The dollar lost 90% of its purchasing power over the five decades to 2012.
The companies that own hard assets like pipeline master limited partnerships (MLPs) and real estate investment trusts (REITs) are a good addition to inflation protection. However, they can pay off in other ways as well. While commercial property and energy infrastructure may need maintenance from time to time, these assets generally tend to increase in value with the decline in dollar purchasing power.
Another benefit of the group is the tax advantages gained by investors or companies. Companies in MLPs and REITs avoid corporate income taxes, so it is a much more financially-efficient way to operate the assets than a traditional company. This means higher profits than would normally be earned.
Within MLPs specifically, the new energy revolution in the United States is driving the need for more pipeline transportation and storage. Railroad carriers are booking strong profits because pipeline construction does not meet demand. That tells me the volume of energy products moving through pipelines will continue to increase even when new pipelines are built. Since most of these companies book their revenue on volume rather than commodity prices, the drop in oil prices hasn’t been catastrophic.
The real estate bubble and bust may benefit real estate investors over the long term. The commercial and residential real estate markets got crushed during the bust, and many regions still see substantial price gains back to fair value. The memory of the bubble should keep markets from overheating for a long time, and property prices could continue their historically stable climb higher.
These aren’t the only themes within dividend stocks, but they should get you started adding some good cash flow to your investing portfolio. Always invest according to your need for return and tolerance for risk, regardless of what someone else says about a stock. For investors wanting an even safer cash flow stream, don’t forget to check out bonds and investments in peer loans.