Note: This article is part of Morningstar's Guide to Dividend and Income Investing special report.
Most of our readers know the virtues of dividend investing. A dividend is always a positive contributor to total return, a key advantage in light of the unpredictable nature of capital gains and losses. Retirees and other investors who need to meet ongoing obligations with their savings benefit from steady inflows of cash. And investors still in accumulation mode can reinvest dividends, building up the future value and earning power of their portfolios.
Dividends are typically an indication that a business is established and financially healthy enough to return cash to shareholders. Dividends also force management to be focused on the long term and disciplined with their capital allocation decisions: After a company declares a dividend, it usually tries to avoid cutting the payout. A dividend cut is a signal that a company's earnings are weakening, which will lead many investors to dump the shares.
Investing in Dividend-Yielders
Unfortunately, it's not always the case that the stocks yielding the most are the healthiest ones with the most cash on hand to return to shareholders. Simply choosing stocks with the highest dividend yield can often result in the purchase of highly risky stocks that are priced low relative to their dividends, due to potential financial distress.
That's not to say that investing in companies that pay higher dividends is a bad idea. (For purposes of this article, let's define "dividend yielders" as stocks with yields higher than the market average of around 2%.) But when investing in dividend yielders, your investment criteria should consider more than just the yield. In order to determine if a company can continue to pay out a high dividend yield, make sure you focus on stocks of companies that are financially healthy enough to sustain and even grow their dividend. (Premium Members can use our economic moat ratings and other qualitative, forward-looking measures to help with this task.)
One potential hunting ground for ideas is the Morningstar Dividend Yield Focus Index, which looks at both backward-looking and qualitative forward-looking measures to find high-yielding stocks that are financially healthy enough to sustain their dividend.
The index uses several screens to narrow the universe in search of high-quality dividend yielders. We first screen the Morningstar US Market Index for dividend-payers. (The dividend must come from qualified income, so real estate investment trusts are not included.) We then apply the quality screens: We search the high-yielders for companies that have Morningstar Economic Moat Ratings of wide or narrow, meaning we think they have competitive advantages that will allow them to continue to earn above-average profits and sustain their dividends for 20 or 10 years, respectively. We also consider a company's distance to default ratio, a metric that uses market information and accounting data to determine how likely a firm is to default on its liabilities.
The 75 highest-yielding stocks that make it through the quality screen are then included in the index. See the current holdings here.
Investing in Dividend-Growers
Companies whose cash flows have translated into a rising payout are known as dividend-growers. These are not always among the highest-yielding securities in the market; in fact, it's important for investors to have reasonable expectations for dividend growth strategies. Investors seeking current income might not be satisfied with a yield of a dividend growth portfolio, such as the Morningstar Dividend Growth Index. In fact, the trailing 12-month dividend yield for that index is only slightly higher than that of the market as a whole: 2.1% versus 1.8% for the S&P 500 Index.
What is the appeal, then? Companies that are focused on growing dividends tend to be higher-quality, cash-rich businesses that hold up well in down markets, participate in up markets, and are capable of excess returns over a full market cycle.
In addition to being core, defensive holdings, companies that are growing their dividends provide some protection from inflation: A rising dividend is fundamental to investors' ability to preserve purchasing power through their equity portfolio.
It's also likely that dividend-growth stocks will be less sensitive to losses during periods of rising interest rates. For example, high-yielding utilities stock intuitively becomes a less attractive income source when yields rise on bonds, a less risky asset class. But because dividend growers tend to sport more modest yields, they were never the first choice for yield hounds in the first place.
The Morningstar US Dividend Growth Index is comprised of companies that we believe are healthy enough to sustain and grow their payout. To find them, we cull the U.S. equity market for securities that pay qualified dividends. (This excludes real estate investment trusts.) Index constituents must exhibit a five-year history of increasing their dividend payments. To gauge the sustainability of dividend growth into the future, eligible constituents must display positive consensus earnings forecasts from the analyst community. As a safeguard against dividend cuts and financial distress, stocks with indicated dividend yield in the top 10% of the universe are excluded. Finally, existing constituents are allowed to remain if they have recently bought back shares and have not decreased their dividend payment.
Constituents must also have reasonable payout ratios, which represents the percentage of earnings paid out as a dividend. Companies with payout ratios above 75% are ineligible, which helps to screen out companies with unsustainable dividends.
Prospective dividend-growth investors may find some ideas among 450-plus current holdings in the index.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.