Need income? Take a look at dividend stocks

Now is a difficult time for investors who seek assets providing regular income. With interest rates at record lows, bonds aren’t a very attractive choice. One alternative is dividend stocks.

Many safe, blue-chip stocks offer dividend yields much higher than 10-year Treasury notes. In addition to providing higher yields than Treasuries, dividend stocks give you a chance for capital appreciation that Treasuries don’t, assuming you hold them until maturity.

“Over the long term, dividend-paying stocks have outperformed nondividend stocks,” says Tim Ghriskey, chief investment officer of Solaris Asset Management in Bedford Hills, N.Y. “There is real power in dividends for total return. The compounding of dividends and dividend increases help total return.”

Indeed, dividend-stock guru Jeremy Siegel, a professor at the University of Pennsylvania’s Wharton School, has calculated that dividends, assuming they are reinvested in the stock, account for 97 percent of historical stock market returns.

If you’re at or near retirement, dividends offer you a stream of recurring income without tapping into your principal.

Many companies paying dividends are large-cap high-quality concerns, such as utilities and consumer product companies. That makes them simpler for individuals to understand than high-flying growth companies. “It’s much easier for an ordinary investor to figure out what’s going on with a utility than a biotech company,” says Josh Peters, director of equity income strategy for Morningstar research firm in Chicago.

Dividend safety

Peters and others recommend a three-step process for selecting dividend stocks. The first question should be, “Is the dividend safe?” he says. You should avoid stocks with extremely high yields because such yields generally mean investors have pushed the share price down in anticipation of a dividend cut.

“Anytime the yield is more than 8 percent, you have to think very hard about whether the market is telling you something about the safety of the dividend,” Peters says. “The last thing you want to do is buy a dividend stock that’s about to be cut.”

He recommends looking for companies whose businesses aren’t very cyclical and that aren’t overburdened with debt. In terms of the payout ratio — dividends to earnings — for tobacco companies it can be 80 percent, as they don’t have to reinvest in their businesses. The ratio also can be high for utilities.

“For most others, the rule of thumb is up to 60 percent to 65 percent is OK,” Peters says. “But beyond that, you need to have a good reason to feel comfortable about the sustainability of the dividend.”

Dividend growth

The second issue is dividend growth. A steadily rising dividend obviously increases your regular income. And as they generally reflect growing profits for the company, dividend increases often signal a rise for the stock price, which increases your total return.

“If the dividend is a consistent grower year in and year out, that generally will be a good investment for you,” Ghriskey says. Past dividend gains don’t guarantee future ones, of course, but they are a good indicator.

The third issue is the stock’s valuation. If the share price is set to tumble, the loss can overwhelm your dividend earnings. “You aren’t escaping market risk, so you have to be careful,” says Jim Holtzman, a shareholder at Legend Financial Advisors in Pittsburgh. “We worry more about total return, and dividends are a part of that.”

Zone of 3 percent to 6 percent

Peters recommends searching for stocks with yields of 3 percent to 6 percent. Stocks yielding less than that aren’t giving enough boost to your total return, which consists of capital appreciation plus yield, and should be in the 8 percent to 10 percent range to match the overall market, he says. And stocks that yield well above 6 percent are generally in danger of seeing their dividends cut.

For investors who have the time and ability to research and closely follow their holdings, buying individual dividend stocks makes sense. That way, you avoid the fees of mutual funds or exchange-traded funds. And those funds might hold some stocks that you don’t want.

But for investors who don’t have the time or ability to research their investments, a fund makes more sense, Holtzman says. “You’re getting a basket of stocks, so an individual company dropping its dividend isn’t as much of an issue.”