How to Build the Ultimate Dividend Portfolio

• 'The true investor will do better if he forgets about the stock market and pays attention to his dividend returns and to the operational results of his companies.' - Benjamin Graham

There are two ways to make money in stocks.

There's the popular way, which is capital gains (i.e. growth) and then there's the not so popular way which is dividends (i.e. income).

Investors tend to get obsessed with capital gains. This is understandable. Who doesn't like capital gains? The more the better.

But dividend investing is different. Dividend investors don't seek growth. Of course, they'll take the growth if they can get it. But they don't actively look for it.

What do they look for?

Stability.

But why stability in particular?

You see, trading and investing, especially long-term investing, can be very challenging to most retail investors. After all, the world of investing changes quickly.

But despite these challenges, the Indian retail investor has faced them confidently ever since the covid crash of 2020.

The new all-time highs made by the market are a source of encouragement. But even during corrections, retail investors have not abandoned the market. The funds keep flowing in, either via direct investments or via mutual funds.

There is a good reason for this stability and it's often underappreciated: Dividends.

Dividend stocks have provided stability to portfolios during the volatile periods of 2022 and 2023. This in turn has helped bring in more money into the market.

This stability has proven the importance of dividends to Indian retail investors in a volatile market. During the recent period of high inflation, dividends have provided steady income and a moderate return on investment.

Dividends also provide an incentive for companies to increase their earnings, so that they can pay an even higher dividend next year. Companies paying out a slice of their earnings to shareholders typically have a record of strong profits. This helps these companies maintain dividend payments in the future.

This attracts even more investors which in turn takes the company's share price even higher.

Investing in stable dividend-paying companies can let you sleep peacefully at night. These businesses will generate steady passive income. The more stable the business, the higher the share of profits that can be distributed.

This is why dividend paying stocks tend to outperform non-dividend paying stocks on average over long periods of time. All else being equal, a company with a higher dividend payout is more stable that a similarly sized competitor with a lower dividend payout.

In this editorial, we will cover the steps to build the ultimate dividend portfolio.

Read on...

Building the Ultimate Dividend Portfolio

First, there is something you should not do as a dividend investor.

You should not blindly jump into stocks with the highest dividend payout ratio.

If a company pays out all its profits as dividends, it may not always be a good sign. It could imply that there's no chance of investing the profits back into the business at a decent return.

This is why it's better to look for a company with plenty of room to increase the dividend payout in the future.

Now let's get to the steps involved in building a dividend portfolio.

Step #1: Shortlist Dividend Paying Stocks

You should look for companies with a long history of paying dividends. This is the most important point. companies with a long history of paying dividends are likely to continue paying dividends in the future.

If a company either doesn't pay dividends or is inconsistent, it's best to avoid it. It may be a good company but it's not suitable for a dividend portfolio.

Luckily this is the easiest step. You can shortlist dividend paying stocks in just a few seconds using Equitymaster's powerful stock screener. It's a powerful and flexible tool which allows you to run your own custom queries.

Step #2: Evaluate the Financials

There are cases where the company may have a long track record of paying dividends, but its financials may not be great.

Every investor has a certain risk tolerance. Some may be comfortable with growth companies that are using debt to fund the growth. These stocks may have a debt to equity ratio greater than 1. Other investors may not be comfortable with such a company.

Now, there is no strict right or wrong answer here. Every investor is different. So, you will need to evaluate a company's fundamentals based on your comfort level to decide if you want it in your dividend portfolio or not.

If you're unsure about how to go about it, then this article can get you started - What is Fundamental Analysis and How to Do it?

Step #3: Pay Careful Attention to These 2 Points

Apart from a company's fundamentals and its dividend paying track record, you will need to pay careful attention to two points.

• Growth
• Competitive advantage

Growth is important because you're looking for a company that increases its dividend year after year. This is necessary to keep up with inflation.

The smart money in the market is always on the lookout for companies that increase the dividend payout during difficult economic situations. Such companies are rewarded with high stock prices.

A competitive advantage is important because without one, a company might struggle to grow after a few years. At that time, it might not raise the dividend payout, or even reduce it. A falling dividend payout ratio is a sure sign of a company that is struggling to handle the competition in its industry.

This is why, when you're looking for dividend stocks, always pay attention to the competitive forces in the industry and the company's position in it.

Step #4: Dividend Yield

Finally, we come to the dividend yield. This is nothing but the dividend per share divided by the stock price. It tells us how attractive the company's dividend is compared to its stock price.

A high dividend yield is desirable for many dividend investors but be careful here.

Often a high dividend yield can mean the company doesn't have much growth prospects and so is paying most of its profits as dividend. This artificially boosts the numerator of the equation which in turn gives a high dividend yield.

Remember, its usually better to own a stock in which the dividend payout can increase over time. This is not possible in the case of a company with poor growth prospects.

Also, a high dividend yield could mean the stock is cheap due to reasons the market doesn't like. The dividend payout may not have much to do with the yield. It's just that the market doesn't like the stock.

These are stocks that have low PE ratios and/or low PB ratios along with a high dividend yield. In these cases, take the time to understand why these stocks are cheap in the first place. You will have to then take a call whether you agree or disagree with the market.

If you think the market is wrong, then the high dividend yield stock might find a place in your portfolio.

But if you agree with the market, then it's best to avoid the stock.

Of course, there is a chance that you might be wrong in your assessment. This is a risk every dividend investor takes when buying high dividend yield stocks.

Step #5: Continuous Monitoring

This is a very important final step that many dividend investors ignore.

Just because a company is a good choice for a dividend portfolio, doesn't mean it will stay that way forever. The business world is highly competitive in the era of globalisation. A company with great fundamentals, paying great dividends, may fall on bad times due to any reason.

Keep a close watch on the fundamentals of the stocks in your dividend portfolio. Track the developments in the companies and in the respective industries regularly.

You may find some stocks don't deserve a place in your dividend portfolio. In such cases replace those stocks with others.

Conclusion

Dividends are the lifeblood of many investors. Dividend stocks weren't popular in recent years but that changed due to the high volatility in the market.

Lured by the prospect of steady income, these stocks are regaining their popularity. These securities are considered a good buffer during times of market volatility. They also are seen as an inflation hedge. This has increased demand for dividend stocks in recent times.

If you want to build a dividend portfolio, you can use Equitymaster's powerful stock screener to check high dividend yield stocks and dividend growth stocks in India.

To know what's moving the Indian stock markets today, check out the most recent share market updates here.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...