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Dividend Investing is an investing strategy preferred by many for its dual benefits of creating steady income while also being an avenue for long-term wealth creation. It is essential, then, to pick the right dividend paying stocks that generate the best returns over the long term.
In the previous article, we covered fundamental analysis techniques and metrics to pick the most consistent and best dividend stocks. This included understanding the measures such as the dividend yield, growth rate, and payout, which can help investors understand the expected dividends being paid annually and expected dividends in the future. Furthermore, the article also looked at fundamental measures such as the Return on Equity, Debt/Equity, and Interest Coverage to understand the Financial health of the underlying company paying the dividends.
Today, we will delve deeper into advanced strategies to pick dividend stocks, including the best sectors to invest in, conducting macroeconomic analysis to find the best times to invest in dividend stocks, and the Dividend Discount Model, which will help you find the fair value of dividend stocks based on the expected payouts.
Before we dive in, I recommend you to check out my book, Live Off Dividends, where I dive into more details and prepare the reader for the investment journey.
Now, let's go.
Macroeconomic Indicators Influencing Dividend Paying Stocks
You can utilize Macroeconomic Analysis, which provides insights into the broader economic conditions that impact various sectors to select the right dividend stocks for their portfolio.
One aspect to keep in mind is that Interest Rates set by the Federal Reserve can significantly impact dividend stocks, especially in sectors such as real estate (REITs) and utilities. Higher interest rates also make Bonds more attractive to dividend stocks by paying out higher yields, potentially reducing the appeal of dividend-paying stocks. Conversely, lower interest rates can make dividend stocks more attractive as a result of the higher yields they provide.
Inflation, a persistent challenge since the pandemic, also impacts a company’s costs and pricing power, potentially impacting its profits and underlying dividends.
Other macroeconomic indicators such as the GDP growth rate, unemployment rate, and consumer confidence can provide the backdrop that influences the broader stock market. Strong GDP growth signals robust economic conditions, which can support higher consumer spending, potentially benefiting stocks from sectors such as consumer discretionary and technology. On the other hand, high unemployment can hurt consumer spending, negatively impacting the same sectors.
Macroeconomic analysis also includes understanding the broader market changes and regulatory impacts that affect specific sectors. For instance, the recent regulations passed by the U.S. and European Union to phase out ICE vehicles could have a long term on Energy Stocks, which may impact their long-term payouts.
Strategic Sector Selection
Sectoral selection is just as important as conducting a macroeconomic analysis, as it helps investors find the best sectors for the current economic conditions and trends.
Dividend investors can use the strategy of Sectoral rotation to move investments between different sectors to capitalize on cyclical trends. Understanding the stages of economic cycles is crucial for sector rotation.
Basically, an economic cycle consists of three phases:
Growth - A period of economic expansion resulting in revenue growth, earnings expansion, and increased consumer spending.
Recession - When the economy weakens as a result of lower spending by consumers and negative GDP growth.
Recovery - The economic recovery follows a recession, with the overall business outlook being optimized during this phase.
Keeping an eye on an economic cycle can help investors not only choose the sectors that are likely to outperform during certain phases of the economy but also pick stocks that will remain resilient and continue to pay dividends even during downturns.
Typically, sectors like financials, real estate, and consumer discretionary lead during the early recovery stages of the economy. Mid-cycle favors growth sectors like technology and healthcare, while late stages might see better performance in industrials and energy. Finally, defensive sectors such as consumer staples and healthcare are more favorable during economic contractions.
This broader diversification across various sectors can reduce the risk of significant losses from any single sector and stabilize the portfolio returns under different market conditions.
A Closer Look at Sectors Offering High and Stable Dividends
Now that we’ve understood the broader economy and sector rotation, let’s examine each sector to determine which offers high and stable dividends and performs well in different economic conditions.
Utilities: Stocks in the utility sector focus on providing services like electricity, natural gas, sewage, and water to homes and businesses, with examples including companies such as Duke Energy and NextEra Energy. These stocks are known for their stable and consistent dividend payouts since their earnings remain resilient and evergreen.
Financials: Financial stocks include banks, insurance companies, and investment firms, which often offer attractive dividend yields. While financial stocks like Bank of America and Old Republic are notable for their dividend track record and payout ratio, they can run at the risk of suspending dividends if financial conditions worsen, leading to higher losses from unpaid loans or higher claims.
Consumer Staples: Consumer Staples include companies that provide goods and services on a daily basis, including food, clothing, or other personal products, being a reliable source of dividends, with examples including Coke or Costco Wholesale.
Real Estate: Real estate investment trusts (REITs) can be a go-to sector for investors looking at high dividend yields. Companies in these sectors are legally obligated to distribute the majority of their taxable income to shareholders, leading to higher-than-average yields.
Transportation: Transportation stocks, such as CSX and Union Pacific, can also offer significant yields. While this sector tends to be more cyclical, certain segments can provide substantial yields with reasonable payout ratios.
The Dividend Discount Model
The Dividend Discount Model (DDM) is a valuable tool for estimating the fair value of a dividend-paying stock by calculating the present value of its expected future dividends.
The DDM is based on the principle that a stock's price should equal the sum of all future dividend payments discounted back to their present value. This reflects the intrinsic value of the stock based on the cash returns expected to be generated for shareholders.
There are two types of Dividend Discount Models: Gordon Growth Model (GGM): This is a commonly used version of the DDM, ideal for companies with stable and predictable dividend growth.
The formula is given by:
V = D/r-g
Where
D is the expected dividend in the next year
r is the required rate of return (cost of equity)
g is the constant growth rate of dividends
Let us take a look at an example to understand this. Duke Energy, which currently pays $4.12/share in dividends annually, is trading at $102/share with an annual dividend growth rate of 1.01%. Assuming the required rate of return to be 7%, using the Gordon Growth Model, we can estimate the fair value of Duke Energy to be $59.52/share, implying that the stock is currently overvalued.
Multi-Stage Models: The multi-stage model is more complex and suitable for companies whose dividend growth rate is expected to change over time. Typically, these models involve different phases, such as an initial period of high growth followed by a transition to stable growth.
For instance, technology stocks such as Meta and Google’s parent company Alphabet have started paying out quarterly dividends of $0.5 and $0.2/share respectively, but it is likely that as these companies continue to mature and growth slows in the future, the dividends paid out will be higher.
It is important to remember that to use the DDM model effectively, investors need to estimate the future dividends, their growth rate, and the appropriate discount rate. The model is particularly reliable for companies in sectors with high dividend yields and low growth, such as utilities or real estate investment trusts (REITs). However, the DDM can be sensitive to the inputs used, especially the growth rate and the discount rate, which can significantly influence the valuation outcome.
The Key to Strategically Pick Dividend Stocks
In this article, we have explored advanced strategies and methods for picking the best dividend stocks, including macroeconomic analysis, sectoral strategies, and the Dividend Discount Model.
Investors need to understand economic cycles and their impact on various sectors and use valuation models like the DDM to select stocks that offer attractive dividends while aligning with broader economic trends, resulting in long-term capital appreciation.
It’s important to remember that dividend investing requires thorough research, strategic planning, and continual reassessment of both market conditions and the underlying financial health of the companies.
I wish you reach your Dividend Horizon,
Alex
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