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Dividend stocks have long been a popular parking spot for spare cash. And for the investors fortunate enough to have stumbled upon a nice lump of capital, these income-bearing investment vehicles are currently on sale.
With the stock market going through a spooky October, the buying opportunities for long-term investors continue to be bountiful. And while not all discounted valuations may be bargains, a few could help propel a portfolio to new heights, potentially unlocking a far chunkier income stream in the process.
So where can investors find the best income stocks today? In my experience, they’re likely to be the ones currently in the gutter.
Diamonds in the rough
Looking at the Fear & Greed Index, it’s clear that the vast majority of investors are currently on edge. And with that in mind, the recent stock market volatility isn’t exactly surprising. But as billionaire investor Warren Buffett has repeatedly said, investors should “be greedy when others are fearful”.
When emotions are running high, it’s easy to make quick, panic-driven decisions that aren’t all that smart. And often, investors end up throwing the baby out with the bathwater, leading to fantastic companies being sold off aggressively.
In the long run, these mistakes end up being corrected during a recovery. But in the short term, spotting such errors early can unlock phenomenal gains in the long run. That’s why, when hunting for value opportunities, I always start by looking at the worst-performing shares in the last six months.
In many cases, sell-offs end up being largely justified. A crumbling balance sheet or a compromised business model doesn’t exactly entice me to invest. But every once in a while, short-term disruptions paired with general market uncertainty can reveal a terrific opportunity.
Looking for sustainable yields
If dividends are the goal then, obviously, I’m only going to be interested in the firms that pay out to shareholders. But while it may be tempting to focus on the highest-yielding opportunities, this may be a critical mistake.
High yields are always welcome. But they’re rarely sustainable. And I’m not interested in putting my grand to work in a company that can’t grow its dividend, let alone maintain it.
Spotting high-quality, dividend-growth opportunities is far easier said than done. Like most of the stock-picking process, there are nuances. However, in my experience, one of the best ways to filter out duds is to focus on free cash flow (FCF).
A company that can consistently generate more money than it needs not only reduces dependence on external financing like debt but also provides the bandwidth to reward shareholders. And if FCF is on the rise, then dividends could potentially follow.
Another metric I like to investigate is the payout ratio itself. Suppose the bulk of earnings are already being redistributed? In that case, the dividend flow may be more susceptible to disruption versus a firm with a lower payout ratio, given it provides a buffer to absorb a temporary downturn in earnings.
