The end of the year is a perfect time to think about your investment journey. Part of that reflection may include identifying mistakes worth avoiding, or identifying portfolio moves that should be made before year-end. You can also dig deeper into a particular sector or type of stock, such as growth stocks versus value or dividend stocks.
Here are three lessons you can use to pick winning dividend stocks to buy and hold in the new year.
There is no more powerful force in the stock market than earnings growth. Earnings growth can make a company that looks expensive based on trailing earnings still worth buying. It can create a snowball effect that accelerates shareholder value by increasing the pace of innovation, dividend increases, buybacks, mergers and acquisitions and more.
Income investors often look for companies that have track records of routinely increasing their payouts. However, that can be expensive and ultimately harmful if a company fails to grow profits. For example, suppose a company passes all its profits on to shareholders through dividends, but it continues to take on debt. That can damage the health of the company and ultimately make it a bad investment.
The best dividend-paying companies can grow their profits at least as fast as their dividend payments. Procter & Gamble (NYSE:PG) is a Dividend King with 68 consecutive years of dividend increases – an impeccable track record. Over the past decade, P&G has grown its diluted earnings per share slightly faster than its dividend. It managed to buy back a significant amount of shares to reduce its share count by 12.8%.
Growing profits and dividends justify an increase in P&G’s value. Investors who have held P&G stock over the past ten years have experienced a 92.3% price appreciation. However, the total return (including dividends) is much higher at 155%. P&G is a great example of how a company with miraculously mediocre earnings and dividend growth can be an excellent investment because of consistency.
Consistency is an important characteristic to remember when approaching dividend stocks. Investing involves trade-offs. Growth stocks offer better potential for outsized gains, but can be volatile and inconsistent. Investors are often drawn to dividend stocks because they are looking for something more predictable that fits their financial goals or risk aversion, or because they want to supplement their income in retirement. Often the best dividend stocks are also the most consistent.
The dividend yield is a company’s annual dividend payment divided by its market capitalization, or more simply, its dividend per share divided by the stock’s price per share. Yields will rise if the dividend grows faster than the stock price, and will fall if the stock price exceeds the dividend growth rate. The best combination is a company that consistently increases its dividend by a significant amount and grows in value – creating greater shareholder returns, driven by capital gains and dividends rather than just dividend income.
There are plenty of excellent dividend stocks with low yields because their share prices have risen significantly. A surprisingly recent example is Walmart (NYSE:WMT). Walmart is a stable, leading company that is also a Dividend King. However, the stock is up as much as 88.3% in the past year. Walmart’s long-term investments are paying off and the company is gaining market share at a time when many of its peers are struggling. The rise in Walmart’s stock prices has caused its yield to fall below 1%, making Walmart no longer a viable source of generating significant passive income. But that doesn’t mean Walmart isn’t committed to increasing its dividend.
Costco Wholesale (NASDAQ: COST) is another retailer that has consistently made outsized profits compared to the market. Costco is a unique case in that it has a small regular dividend but sometimes pays large one-time special dividends when its cash position reaches healthy levels. It’s Costco’s way of returning money directly to shareholders through dividends. Again, Costco isn’t a good option if you’re looking for stable and consistent quarterly dividend payments, but the company is very committed to using dividends to return capital.
You may know Sherwin Williams (NYSE: SHW) as a paint company. It’s also a high-octane stock that continues to crush the broader market. Sherwin-Williams has had an incredible year. In February, it increased its dividend by 18.2%, marking its 45th consecutive annual increase. It joined in November Nvidia as the latest additions to the Dow Jones Industrial Average.
Over the past decade, Sherwin-Williams has more than tripled its dividend, but its stock price has quadrupled. Sherwin-Williams may only yield 0.7%, but shareholders don’t mind at all given its epic profits.
Microsoft (NASDAQ: MSFT) pays more dividends than any other US-based company. Over the past decade, Microsoft has increased its dividend like clockwork by about 8% to 11% per year, while at the same time buying back enough shares to more than offset its stock-based compensation costs. But because the company is worth so much and has grown in value faster than it is increasing its dividend, the yield is only 0.8%.
Walmart, Costco, Sherwin-Williams and Microsoft no longer return a decent amount of money if you were to buy the stocks today, so they should be viewed as growth stocks rather than value or income stocks. However, they offer much higher returns on costs for long-term investors.
In my opinion, return on costs is a concept that receives far too little attention when discussing dividend stocks. Return on cost is the easiest way to avoid punishing a company for being a strong performing stock. Instead of taking the dividend per share and dividing it by the current stock price, take the dividend per share and divide it by the price you paid for the stock.
For example, let’s say you bought Sherwin-Williams five years ago for $192.85 per share, even though the stock had a quarterly dividend of $0.377 per share. and Microsoft at $151.75 per share, while it had a quarterly dividend of $0.51 per share. As of this writing, Sherwin-Williams has a stock price of $384.96 per share and a quarterly dividend of $0.715 per share, and Microsoft has a stock price of $443.57 and a quarterly dividend of $0.83 per share.
|
Company |
Hypothetical cost basins |
Current stock price |
Current annual dividend |
Current return |
Hypothetical return on costs |
|---|---|---|---|---|---|
|
Sherwin Williams |
$192.85 |
$384.96 |
$2.86 |
0.74% |
1.5% |
|
Microsoft |
$151.75 |
$443.57 |
$3.32 |
0.75% |
2.2% |
Data sources: YCharts, Yahoo! Finances.
Based on the amount of money you invested in each stock five years ago, you would return 1.5% on Sherwin-Williams and 2.2% on Microsoft – much higher than current dividend yields. If you were to do the same exercise, but assume that both stocks were purchased 10 years ago, the return on cost for Sherwin-Williams would be 3.4%, and for Microsoft it would be a whopping 7%!
Thus, an initial investment in either stock would generate a significant amount of passive income, in addition to the gains made by the appreciation of both companies.
When it comes to dividend investing, it can be easy to fall in love with high returns. While some high-yield stocks are certainly worth a closer look if the company shows signs of a turnaround in business, it’s important to take a step back and focus on the fundamentals of dividend investing. A dividend is only as strong as the company that pays it. So first and foremost, you should invest in companies you believe in. Then see if they offer a quality dividend (and not the other way around).
By staying consistent and applying these core concepts, you can build a strong and growing dividend portfolio that focuses on quality rather than quantity.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends Costco Wholesale, Microsoft, Nvidia, and Walmart. The Motley Fool recommends Sherwin-Williams and recommends the following options: long January 2026 $395 calls to Microsoft and short January 2026 $405 calls to Microsoft. The Motley Fool has a disclosure policy.
3 lessons dividend stock investors can benefit from in 2025, originally published by The Motley Fool
