The Power Of Dividend Investing [Part 2] - Choosing the Right Stocks for Dividend Investing

Dividend investing helps us create passive income so we can achieve financial independence. In my previous article, I wrote on the benefits of dividend investing and how we can essentially get more than 10% yield on our investment. You can read part 1 here: The Power Of Dividend Investing [Part 1]

The question now would be, how do we pick the right dividend stocks for successful dividend investing? Let's take a look at some criterias for dividend investing in part 2 of this series. But before we get right into it, let me show you the pitfalls to avoid using the story of this once hot stock listed on the Singapore exchange.

Pick the wrong stocks and suffer
As with all investments, if we do it the wrong way, we would lose money. This is the same for dividend investing. Not only do we get lesser dividend if we pick the wrong stocks, some stocks will also cut out dividends totally.

Creative Technologies - The Once Hot Stock
One example of such a company which performed poorly over the years is Creative Technologies. You may remember the sound blaster sound card which used to be popular for PCs and the many breakthrough sound technologies which they have. However, in the end, Creative did not manage to keep up with the competition and the technology changes and fell behind over the years.

Let's take a look at its stock price from 1998 to now:

Image from Yahoo Finance (Click to enlarge)

Creative Technologies share price was once at a high of $59.50 in year 2000. The share price now is only $1.37 cents. This is a scary drop and those who bought it at a high would have got their fingers burnt badly.

As for dividends, Creative paid a stunning 50 cents dividend in 1998 which consist of a special dividend of 25 cents. In 1999, dividends paid was 25 cents. That was probably about 10% yield when its share price was about $20 before year 2000. What about the dividends now? Creative, although has a net loss reported year after year, still pays dividend to its share holders. Dividends paid is only 4 cents in 2014. That is a stark difference from the 25 cents and 50 cents dividends paid last time.

When choosing stocks to invest, we should not just look at dividend yield. Even with a 10% dividend yield, dividends could drop and we could lose money.

Choosing the right stocks for dividend investing
Each of us have our own different ways of choosing stocks. We also have our own different strategies for building our investment portfolio. Some may invest more into growth stocks, some practice value investing while others go into dividend investing. No matter what, there are always some basic criteria or check list which we can look at.

1. Look for Businesses with Strong Competitive Advantage
We always need to ask ourselves why is the firm suitable for investing? Are profits still coming in and if so is there a threat that competitors can steal away its customers?
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." -- Warren Buffett
When we invest in stocks, we have to think like a business owner. Investing in stocks is owning a part of a company. When we have this mindset, we would want to invest in a company that can probably survive as long as possible.

It is not easy to find stocks with competitive advantage. Some industries such as utilities and energy have greater competitive advantage as compared to industries such as F&B. Technology companies such as Creative could not create a strong enough competitive advantage to keep competition out. Once another company which has another breakthrough technology comes, Creative losses a big portion of its business and its profits slumped.

A business with strong competitive advantage can stay ahead of times and keep competition away. It is like the game of monopoly where the purpose is to dominate the entire market by buying as many properties as possible so your chances of getting money from other players is higher. If businesses can monopolise their market and keep competition out, then they have a greater competitive advantage.

2. Look for Undervalued Business
No matter how good a business is, we should not overpay for it.

"Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." -- Warren Buffett
Everyone loves discounts. If we can buy a great company at a discount, it is a good deal. During the 2008 financial crisis, stocks were trading at extremely attractive valuations. Many blue chip companies had a PE ratio of less than 10. PE ratio is the number of years needed for investors to get back their initial investment assuming all things remain constant.

We can use Price to Earnings Growth ratio (PEG) to determine if a company is undervalued or at fair value. This is mostly useful only for small companies. The formula for PEG is PE Ratio divided by compound annual growth rate. At the end of the calculation, if PEG is 1x, it means the stock is trading at fair value. If PEG is 0.5x, it is undervalued and we can say this stock has a margin of safety of 50% (less than 1 is undervalued). If PEG is 2x, it is a sell signal. Take note again that PEG is useful only for small growth companies.

Next, we can use the discounted earnings model or discounted cashflow model to calculate the intrinsic value. This is suitable for blue chips or mature companies. There is a free intrinsic value calculator which you can download from a fellow blogger's site here. There are instructions for you to follow there. If intrinsic value is $1 and stock price is trading at $0.50, this stock is said to be undervalued with a margin of safety of 50%. However, do note that blue chips companies normally trade at a fair price rather than a bargain price.

For companies which relies on its assets to generate income, such as REITS and property counters, we can look at it net asset value or price to book ratio to determine if the company is trading at a discount or otherwise. If a stock price is at $2 and its net asset value is at $4, then the company is deemed to be trading at a discount of 50%. This seems like a good buy at first glance. However, it is always not that simple as companies would include assets, such as development properties, as part of their assets. We should exclude the development properties and assume they are not sold. A company's assets will be further broken down under the notes to financial statement.

Below shows the balance sheet of Capitaland:

In the balance sheet, we can see current assets and non current assets. Development properties is listed under current assets which we may exclude. If we want to look deeper into the types of assets, for example under the property plant and equipment, we can go to note 3 as stated in the balance sheet. When we go to the notes to financial statement under point 3, we will see the below information:

The break down of Capitaland's property plant and equipment can be seen under the notes to financial statement. To analyse companies at a deeper level, it is essential to refer to the notes at the back of an annual report.

If you're unsure of how to read financial statements, you can refer to my guide below:

3. Beware the temptation of high yields/dividends
When investing for income, we like to see good dividends which translates into high yields on our investment. Imagine if the yield is 10%, every $10,000 invested will give you $1000. It is really tempting to go for high yields. However, as investors who invest for income, even though high yields seems attractive, we should not jump straight into in.

Jumping straight into a high yield stock is like jumping into an ocean without knowing if its water is shark infested. It all seem good from the outside but if we look deeper, there may be dangers lurking ahead. A company which pay out high dividends have to get the money from somewhere. It can be paid from its income or it can be paid from its existing cash.

There are a few questions we need to ask ourselves when investing into stocks for passive income.

1. Where does the company pay its dividends from?
2. Are the dividends sustainable? Will the company continue to grow?
3. What's the trend of its past dividend payouts? Is it increasing or decreasing year by year?

Since we're investing for income, we want that income to be sustainable and even better if its increasing yearly. Look at the company's business structure for clues on where they derive its income. If income is not stable, most likely the high dividends are not sustainable as well. This is especially so for REITS where their income is derived from rental collected.

4. Understanding The Risks of a Company

Sometimes, companies can take on a huge amount of debt in order to expand the company and drive up profits. It is crucial to understand any risks which might come from taking on too much debt and keep track of how a company is performing by reviewing its financial results as and when available. A business with a strong competitive advantage can use debt to its advantage while a business which is cyclical in nature may succumb itself to danger when situation turns bad for them.

Also, companies may have a high dividend payout ratio to attract investors when they just started out but this dividend may not be sustainable. A lower dividend payout ratio is generally preferred as these companies can still raise its dividends even if its profits drop later. On the other hand, a company which has a high dividend payout ratio will suffer cut in its dividends when profits drop. However, this will not apply for REITS which have to payout 90% of its net income after tax to shareholders.

I hope the 2 part series on dividend investing has given you some insights on how it is possible to generate passive income through it and also the strategies in selecting dividend stocks. Market has been volatile recently. Dividend investing is still a better choice as we shareholders get dividends even during a bear market. Nevertheless, do invest safely in the right stocks!