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Tips for Finding the Best Dividends

- By Rupert Hargreaves

Everyone loves dividends. Dividends and dividend stocks are the backbone of any portfolio, providing a steady income through both the good times and the bad, accelerating returns and allowing investors to continue to cost average even when times are tough.

However, picking the best dividend stocks is a tricky process. You should never chase yield because more often than not such a strategy will end up costing you more than you ever stood to receive in dividends.

For example, if a company with a dividend yield of 5% suddenly decides to cut its payout in half the stock could fall by as much as 50% before the yield returns to previous levels and income seekers start to bid the stock up once again. This is an extreme example, but it shows how damaging chasing yield can be to your portfolio.

To help you avoid such a disastrous scenario, here are some tips to help you seek out the market's best dividends.

Contrary to popular belief, companies with the lowest dividend yields tend to have the most sustainable payouts. The reason why this is the case is because these companies tend to have the highest dividend cover and the most conservative dividend policies. According to Tweedy Browne's booklet, the "High Dividend Yield Return Advantage: An Examination of Empirical Data Associating Investment in High Dividend Yield Securities," while high dividend yield stocks have outperformed those with low yields, the best returns have not come from those with the highest yields.

Instead high yields coupled with low payout ratios have produced the best returns.

Over a 16-year period from 1990 to June 2006, analysts at Credit Suisse studied the returns of dividend stocks with high yields and low payout ratios and those with high yields and high payout ratios. The analysts found that those stocks with a high payout ratio and high dividend yield returned an annualized 11%. Those stocks with a low payout ratio and high dividend yield returned a staggering 19.2% annualized. Those stocks with a low payout ratio and low dividend yield also achieved a higher annualized return than stocks with a high payout ratio and high dividend yield. Stocks falling into this bucket produced an annualized return of 16.9%. Companies with a high payout ratio and low dividend yield produced a return of 8.6% per annum, the lowest return of all the return samples.

The conclusions of the above study bring me onto my second point. Dividend growth is a key but often overlooked component of dividend analysis.

If the company is paying out all of its earnings to investors via dividends, there is no scope to reinvest retained profits. If a company isn't investing for growth, is the dividend sustainable?

Warren Buffett (Trades, Portfolio) famously does not pay a dividend to shareholders of Berkshire Hathaway (BRK-A)(BRK-B), instead preferring to reinvest group profits into growth. This strategy has generated staggering returns over time, returns far greater than any individual investor would have been able to achieve. I'm not saying this is the perfect dividend strategy (it is an attractive dividend alternative as you can create your own dividends at a lower tax rate by selling Berkshire stock as when you need), but it is an excellent example of how reinvesting profits can generate more growth than paying dividends to investors.

In business cash is king and if you are looking for a sustainable dividend then following the cash is a surefire way to put you on the right path. Cash as a percentage of assets as well as cash conversion ratios are critical. The more cash a company generates the better and cash conversion can be used as a proxy for assessing earnings manipulation. On the topic of debt, when interest rates begin to rise, a company's survivability will depend on its ability to meet higher interest costs while still paying dividends to investors and reinvesting for growth. If there is no debt on the balance sheet, the company won't have to make this trade-off.

Disclosure: The author owns no stock mentioned.

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This article first appeared on GuruFocus.