Picking good dividend stocks : Fundamentals

Individual stock picking is hard. There are just so many options. Not only is it overwhelming, it is very easy to get it completely wrong. How do you know if a stock pick is really good? What qualifies as “good” in the first place?

Let us first focus on basics.

Peter Lynch, a former manager of the Magellan Funds at Fidelity Investments, is known as one of the most successful investors in the world. I have learned a lot from his writings and talks, mostly because I can relate to how he can simplify investing for average joes such as myself.

Perhaps the best advice I received through Peter Lynch is the quote I have referenced in the picture above. Let me elaborate on that a little more.

Do this exercise for me: Dissect your daily routine by thinking about the stores you shop at, the restaurants you dine at. Look around your office or your home and monitor the products you use on a daily basis. Some of these products are from businesses that you have already heard of. For instance, that post-it note that you are using at office is from 3M (ticker: MMM), a famous company that is known for several such products that you might be using around your office and/or home. That iPhone you are using, is from Apple (ticker: AAPL), another famous company. That Tylenol tablet that you consume when you are not feeling well is from another famous company called Johnson and Johnson (ticker: JNJ).

You get the idea. As a consumer, you already know of several such companies simply because you are buying/using their products. As it turns out, ALL of the above companies also happen to pay cash back to their shareholders, just as a thank you for investing in their business. How cool is that!

So does this mean you should blindly invest in every such company that you can find around you. Certainly not! But you have a better chance of success when investing in a business that you can understand or already know about rather than investing in a business that you have never heard before in your life.

With all that said, in addition to knowing a little bit about the business, I also use the following basic rules to screen such stocks:

  1. Companies with a good starting dividend yield: Typically, I don’t have a cut-off as such here. But an unusually high yield number might be a red flag and point to something wrong with the business.
  2. Companies with a reliable history of growing dividends: I normally look for a history of atleast 5 years.
  3. Companies that have a steady dividend growth rate: I look for Compounded-Annual Growth Rate (CAGR) of atleast 5%.
  4. Companies where the dividends are relatively safe: usually determined by looking at the dividend payout ratio. I look at companies where the payout ratio of less than 65% (Note: The only exception to this rule is when I am considering investing in Real-Estate Investment Trusts or REITs. More on this in a future post).

Note: I highly recommend reading this page on Investopedia to familiarize yourself with the some of the above terms.

This just serves as a starting point. Once I have a filtered down list of stocks that I could potentially own, I begin researching the companies further to see if they are a good fit to my overall investing strategy.

Disclosure: Long MMM, AAPL, JNJ

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