The Best Companies for Dividend Investors

Analysts advise against looking for businesses that pay the highest dividends. Consider the cash flow.

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Investors have been drawn to mutual funds and exchange-traded funds that invest in dividend-paying stocks. They are making the wager that owning stocks that are at least paying dividends will pay them if the stock market has another difficult year.

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Which businesses can investors trust to continue paying dividends is the question.

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Just under 200 businesses ceased paying dividends during the epidemic in order to conserve money. Several of them have started paying dividends again in the last three years, but some haven't, and the newest Global Dividend Index from Janus Henderson predicts that overall dividend growth will drop to 2.3% in 2023.

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Although while the economy is still recovering from the worst effects of the epidemic, ongoing inflation and increasing interest rates are putting pressure on the balance sheets of businesses, which may deter them from paying dividends. Some businesses recently revealed plans to reduce their payouts.

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Many of the indefinite pauses and recent dividend reductions, according to Max Wasserman, founder and senior portfolio manager of Chicago-based Miramar Capital, are the result of ineffective capital-allocation techniques.

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What you're witnessing, according to Mr. Wasserman, are businesses that have raised their payout ratio to such an extent that any disruption in their business model puts their payouts in peril. In order to maintain their status as dividend "aristocrats" or to remain on the radar of mutual funds and dividend investors, several corporations have been stretching their balance sheets, which has hurt their cash flows. They decided to reduce the payout in reaction to rising debt costs, inflation, and uncertainty.

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The timing of a dividend cut, according to Antonio DeSpirito, head portfolio manager of the BlackRock Equity Dividend portfolios, can provide information to investors about the underlying health of a company. Based on our research, it can be dangerous if a company makes a cut that is not in line with its normal business cycle. It typically indicates that a business has a chronic secondary issue. The likelihood of a stock recovery is lower, he claims. "There's a bigger likelihood the stock will rebound if you see a business cut during a slump."

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Inquire about sustainability

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So, what qualities in a company should dividend investors look for? R. NFJ Investment Group's managing director and senior portfolio manager, Burns McKinney, advises investors to consider the company's cash flow in addition to its dividend. Although it may be alluring to search for the largest payouts or the best dividend yields, cash flow, according to him, is a sign of sustainability.

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The best dividend firms, in his opinion, are those that have carefully considered their strategy and have a clear philosophy behind it. The existing cash flow and their plans for long-term business growth should be the foundation of this.

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Messrs. McKinney and Wasserman both contend that high-quality dividend payers ought to increase payouts consistently over time, preferably keeping up with inflation. They assert that capital-allocation plans should take the risk of an economic slowdown or recession into consideration. Both anticipate that high-quality dividend payers will increase dividends in 2023 despite the strain that inflation and debt costs are putting on company balance sheets.

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Mr. Wasserman claims that the increases might not be extremely high. "If a corporation has consistently increased its dividend by 5%, they might do 3% this year. Yet if they continue on their current course, rises are what we can anticipate.

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A Number Of Tactics

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According to Daniel Sotiroff, a senior analyst at Morningstar Research Services, a division of Morningstar Inc., "When you are focused on companies that are growing the dividend, that tends to mean that these are highly profitable companies." Dividend funds may offer some protection to fund investors in the current market climate. In uncertain times, investing in them may be a protective move, he claims. According to Morningstar, the average loss for dividend funds last year was 6.68%, whereas the S&P 500 index had a 19.4% loss.

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With dividend funds, investors can follow a variety of different strategies. There are funds with a broad focus, such the Invesco Dividend Income Fund (FSTUX), which invests across sectors in businesses like Johnson & Johnson and Bank of America Corp., two corporations that have historically paid dividends. It has a 0.66% expense ratio.

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Investments in dividend-paying companies that outperform a chosen benchmark index are made by dividend-yield funds. Since many of them invest only in one or two sectors, Aniket Ullal, head of ETF analytics and data collection at CFRA Research, says these funds means that investors the option of taking a more sector-focused approach.

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Through its Vanguard Dividend Appreciation ETF, Vanguard provides a dividend-appreciation strategy (VIG). The index that the fund follows, the S&P U.S. Dividend Growers Index, only includes businesses with a track record of raising dividends. The fund owns all of the index's stocks and charges 0.06% in expenses.

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Each of these tactics "will play a different role in a portfolio," according to Mr. Ullal. "When you concentrate on yields, there may be a trade-off because you raise the concentration risk in a portfolio. Each investor must determine whether that is worthwhile to them.