There’s been a decidedly nervous undertone as I’ve spoken with investors so far in 2020. Both socially, politically and from a public health perspective, much remains uncertain. For investors, uncertainty often leads to fear, worry, and in some cases, jumping in and out of the market. This is never an easy or ideal place to be.
One answer to this broad question: dividend-paying stocks. These are usually well-established companies with a track record of distributing cash back to shareholders. There can be an inherent feeling of stability in them. The thought of steady income can provide a comforting proposition in times of market discomfort, which is where we find ourselves today.
Before we dig deep into one formula you can use to find quality dividend-paying stocks, let’s look at the challenges that investors, and the world at large, are currently facing.
The new coronavirus, which originated in China’s Hubei province, has spread stateside. Americans are panicking as headlines about the outbreak continue to spill out. While the epidemic remains relatively contained, the precautions we’re taking to prevent its spread — while all good ones — are scary.
In the wake of the virus’s appearance, President Donald Trump, by proclamation, instructed officials to take “all necessary and appropriate measures to facilitate orderly medical screening and, where appropriate, quarantine of persons allowed to enter the United States who may have been exposed to this virus.”
The fear around this epidemic has gripped us. There are concerns that the coronavirus will cause a slowdown in the economy both globally and in the U.S.
Big-name businesses operating in China are shuttering their doors while the disease runs its course. Think Apple stores, Ikea, Yum China (the parent company of fast-food chains KFC and Pizza Hut in China). Starbucks, for one, has closed over 2,000 locations in response to the virus.
Here at home, airlines are suspending flights to China, such as Atlanta-based Delta, United, British Airways and American Airlines. Across the globe, more than 70 airlines have ceased flights to the country.
One truth to hold onto in times like these is that markets are resilient. That doesn’t mean they don’t sometimes tumble — it means that, at some point, they recover. During the Asian flu and SARS epidemic, we saw this truism play out. It will play out here, too. While the coronavirus is serious and alarming, it’s not likely to pull down the economy for good. We will make it through. We just don’t know the when or how of it yet.
As if this wasn’t enough to make us worried, there’s also the present political uncertainty our nation is now facing. We’ve got a slew of Democratic candidates on the field. They range from the well-known name of Joe Biden to the lesser-known, more independent Michael Bloomberg, all the way to the self-proclaimed Democratic-Socialist Bernie Sanders.
The “S-word” is making people nervous. With a socialist president comes a leveling of the status quo and an injection of disparate thinking and policy. It would be a hard left from what we’ve had for the past four years, and there would be numerous ramifications. If there’s even a whiff of socialism on a candidate and they make it into the White House, it’s widely believed the market would take a turn for the worse.
Now that we’ve walked through the minefield of uncertainty that surrounds us today, let’s talk solutions.
While there’s a variety of solutions for investors, today I want to focus on dividend-paying stocks. In my opinion, these are paramount to a well-balanced portfolio. To have a stock perform well is one thing; to have it perform well while spinning off cash for you to reinvest is another.
So, how exactly do you find quality dividend stocks? There’s a formula that I like to use, and I want to share it with you as an example. This is a rough sketch of how we at Capital Investment Advisors choose stocks.
Start with the S&P 500 universe. Screen for all that fit into the $5 billion and above category. Next, look for the companies that have reasonable forward P/E (price to earnings) multiples, looking for the realm of 20x or less.
Once the list is tightened, eliminate companies that aren’t healthily growing their dividends – the bar should be around 5% growth or more each year.
Now screen for a particular free cash flow (FCF) level relative to the company’s size account for debt levels. Free cash flow boils down to the company’s operating cash flow minus capital expenditures (excluding acquisitions).
We use this data point because it’s a way to get a handle on the cash generated by the business after adjusting for the cost needed for ongoing investments. By excluding acquisitions, we filter out one-time expenses that don’t accurately reflect the “iron-clad” number required to keep the business going. FCF is what can be used to buy back stocks, pay dividends, reduce debt, buy other companies, expand R&D, etc.
The last step in the selection process is to ensure the companies aren’t overleveraged. Meaning we don’t like too much debt, given bad times can become worse for highly indebted companies. We like to look for companies that have a low level of debt relative to earnings.
What we should have now is a basket of companies that are attractively priced with nicely growing dividends and very manageable debt. This is the kind of company I want to own during a downturn and in a market upswing.
While there is only so much we can control in the world around us, we can control the investments in our portfolio. Do your research to determine if this process helps you sleep well at night … regardless of the headlines.
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. The information contained in this piece is not considered investment advice or recommendation or an endorsement of any particular security. Further, the mention of any specific security is solely provided as an example for informational purposes only and should not be construed as a recommendation to buy or sell. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.