Learn how to find good dividend stocks to invest in, offering a great yield as well as capital gains potential. This dividend stock strategy can be utilized by investors, or day or swing traders seeking to put unused capital to work. See the technical and fundamental criteria to look for, as well as how to quickly find trades.
The dividend strategy below is not for everyone. It’s not a completely passive approach and requires some research. It requires spending about an hour each month so you always have other trade candidates in case one of your current positions closes.
Some people like dividends, others hate them. Warren Buffett is not a fan of dividends. If a company is doing well he would rather see those funds put back into the company instead of being paid out to investors. The idea is that those funds will continue to help the company grow over the long-term, while paying out dividends means less internal capital to grow with. There are a lot of investors on the other side of the fence too. As the above data shows, the typical investor is better off in solid dividend-paying stocks. This article will not debate the merits of dividends. Rather the article looks at a strategy for trading dividend stocks once you have already decided you want to receive regular cash payouts from at least some of your investments.
Technicals, Price, and Dividend Yield
I’m an active trader. I day trade and swing trade stocks and currencies, yet but like many investors, I face the issue of getting nearly zero percent interest on any capital that is sitting in a bank–a problem faced since 2009 by investors holding cash. Investing in some dividend stocks utilizes that capital, producing a return. While there is always a risk of losing on individual trades, not utilizing capital also has a downside: the purchasing power of those dollars, sitting in a bank and doing nothing, continually decline.
The dividend yield, a portion of our expected return, is the dollar amount of the yearly dividends received divided by the purchase price of the stock. Multiply the result by 100 to get a percentage. If you make multiple purchases of the same stock at different prices, then the dividend yield is yearly dividends divided by the average purchase price.
The price of a stock fluctuates daily, going either up or down. Regardless of the direction of the price you have some reasonable assurance that you’ll at least make the dividend yield (assuming dividends payouts are consistent and sustainable). When you buy matters, though. If a stock is fluctuating between $11 and $15 over the course of several years, why buy it at $15 when you can buy it at $11 or $11.50? If a company pays a $1.24 yearly dividend, the price you buy the stock at makes a significant difference in your dividend yield.
- Dividend yield when buying at $11.5: $1.24 / $11.5 = 10.78%
- Dividend yield when buying at $15: $1.24 / $15 = 8.26%
Would you prefer to make 10.78% on your money, or 8.26%? In this example, it may not seem like much of a difference, but the former return is 30% higher than the latter! Over many trades, and compounded over many years, a couple percent difference amounts to a staggering amount of money.
For more volatile stocks, where you buy it makes a huge difference in your dividend yield. Even a calm stock can move big during years where the overall market is volatile…like 2008/2009. Buying at $50 is a lot different than buying at a $100. Buying at the lower also price means more upside potential, assuming we are buying near the bottom of a market cycle where the price typically rebounds from–more on this a bit later. More upside potential means more profit when the stock is eventually sold.
The goal is to buy only good dividend stocks at a good price offering a good yield. “A good price” is subjective. There are no guarantees that the price won’t drop after we buy it, but if we wait for a price that offers us a yield we are happy with, then even if the price drops a little it doesn’t matter. If we bought the above stock at $11, and it falls to $10 before starting to move higher, that isn’t a major concern. We couldn’t know it would fall to $10; it was moving between $11 and $15, so $11 was a good place to buy.
Buy a few dividend stocks at a good price with a good yield, and then control the risk on them. Buy them near the lows of their long-term price ranges, or when the stock pulls back to a multi-year rising trendline. Don’t try to catch a falling knife. The stock may be moving into a support zone, but make sure it stabilizes there before buying. A stock in rapid descent should be left alone until it stabilizes and shows evidence that the price is starting to rise again. You don’t need to pick the exact bottom to make money.
On a stock chart, I look at between 5 and 10 years of price action. I look at the chart to see what price area the stock has typically bounced off of. That’s the area I want to buy. The price could still drop after we get in, as it is a subjective decsion. This approach requires patience, although there are always good opportunities out there.
The chart below shows an example of this approach. We can see that buying near prior established lows provided some of the best prices seen over the last several years. Buying opportunities occurred in 2009 and 2015, as by that time the support area was established (from the first low in 2008). Buying near the first support level at $7, or lower support level near $5.50, provided a great dividend and also provided upside potential as the stock has bounced to at least $11 each time it reached support. If purchasing at $5.5 the dividend yield was 18.17%.
One of the first questions people ask is “Should I buy it a the higher support level or the lower one?” It’s a trade-off. Buying at the higher one, around $7, in this case, means we are more likely to get into the trade, but our dividend yield and profit potential will be lower than if we bought at the lower support area. On the other hand, with many stocks, the price may never reach the lower support area we have identified. Thus no trade, and we may end up missing out on a great trade. My preference is to wait for the better price.
Buying a Dividend Stock Based on Dividend Yield and Favorable Price (2015)
The chart above was originally published in September of 2015. The following chart shows what happened after. In early 2016 the price revisited the ideal buy zone. The price then rallied above $9.50 by early 2017. The price then declined, after not quite reaching the original target, but still producing a sizable capital gain plus the dividends received all along.
Don’t Trust Support Levels Forever
As new information comes available, we need to adapt. In 2015 and 2016 the price revisited the support area for the first time in many years. It then proceeded to rally, but not as high as expected before declining again. The new lower high resulted in drawing another trendline pointed down at a steeper angle. This indicates less upside going forward. The next rally may only take the price to $8 or $8.50. While we can’t know for sure where the price will go, the very basic assumption from this chart is that gains are getting less and less over time.
The stock revisited the ideal buy zone in 2017, and may revisit it again in the future, but because the gains are getting smaller, it is no longer worth buying this stock in the same price area we did before. Better to move on and look for another trade candidate. When we discuss fundamentals a bit later, we will also see that the profits for this company (found in the financial statements of the company) have been declining steadily. While $6 was a good buy for this stock back in 2015 and early 2016 when the company was generating about $1 in earnings/share, now that the company is making between $0.29 and $0.70/share between 2016 and 2018, buying at $6 no longer offers the same deal.
On the 2015 purchase near $6 the price to earnings ratio of about 6:1. To get an equivalent ratio with earnings near $0.50 the purchase price would need to be about $3! We’ll discuss this a bit more later on. But the point is that we want to buy stable or growing companies at good prices with lots of upside. As the capital gains potential declines or the company starts shrinking (in terms of their earnings) over multiple years, then I am no longer interested in the stock.
We also don’t want to buy a stock for the dividend alone, without considering the capital gains. Even if we are making a 10% a year dividend, a stock can easily fall much more than that if we don’t pick our investments carefully, or have poor timing on our buying and end up paying way too much for a stock.
The easiest way to control risk is by position size. That means don’t invest more than 5% in any single stock. If you have a $50,000 portfolio, then you buy $2,500 of each stock you want. If the stock goes to zero you have only lost 5%. If you research the companies, the likelihood of it going to zero is small, which is why we are willing to risk 5% of our capital. This percentage can be adjusted to suit your preference.
Some traders prefer putting up to 10% of their capital in each trade. They feel it is better to invest in the top ten stocks you find with all the capital you have, as opposed to using all the capital to buy 20 which may include stocks not quite up to the quality of the top 10. How you choose to allocate is up to you, but regardless of which method you choose, don’t put all your capital in only a few stocks. Spread it over at least 10 or more stocks. This typically means you won’t be putting all your capital to use at one time. When a good opportunity arises, buy. Then a few months later another may opportunity come up, buy again. It may take a year or more until the capital is fully invested. As trades are closed, that capital can be used to finance new trades that are found.
If you are risking 5%, take 5% of the account balance and that is how much you can buy of each stock. If your account is $100,000, buy $5,000 worth of each stock you find. If the share price is $10, you can buy 500 shares. If the share price is $100, you can buy 50 shares. Adjust accordingly if you wish to risk 10%, etc.
Risk can be managed further with the use of a stop loss order. It gets you out of the trade if the price moves too much against you. In the first PSEC chart above, the price hit a low of $5.73 in 2008. Giving the stock a bit of room, if I buy in this region in the future, I can place a stop loss at $5. Let’s say in 2016 you saw this trade, and bought it at $6.30 once the price entered the buy zone and then started to reverse back to the upside. If the price keeps dropping after we buy, we don’t want to hold it forever. We draw a line in the sand and say if the stock reaches $5, I will get out and move on.
If we allocate 5% of our capital to a stock, and set a stop loss, the damage on any single trade is likely to be quite small in terms of our overall account value. On a $50,000 account we put in $2500 (5%), which buys 2500/6.30 shares = 396 shares. We bought at $6.30 and will get out if the price drops to $5. That means we are risking $1.30/share X 396 shares = $514.8. That is only a little over 1% of the $50,000 account balance. Risk is well contained.
I like to use profit targets. On that PSEC chart above, we can see that at the time of the 2015 or 2016 trades the price had been bouncing off support and then reaching the declining trendline. That declining trendline gave a ballpark figure of where to get out at. At the time of the time, the estimated target was near $10.50. Had the price reached this target we could have gotten out with our capital gain ($10.50 – $6.30 = $4.20 x number of shares), and all the dividends collected over the course of the time holding the trade. At the time of the trade, dividends were $1 per year, so if buying $2,500 worth of stock (396 shares at $6.30) the total gain is $2059.2, or about 82% on the capital invested.
Life doesn’t always go as planned though. If the price nears the target but then reverses aggressively, I will typically just get out. Take the profits and dividends provided. There is always another trade. In the case of PSEC, the price went above $9.50 but not to $10.50, and then had a very aggressive reversal. The stock traded around $8 for some time, so there was ample time to take profits between $8 and $8.50. The actual profit is less than our original estimated profit, but still respectable: 396 shares x $1.7 profit per share = $673.2 + $396 in dividends = $1069.2 (or $42% on invested capital).
Profit targets, as well as other exit methods such as trailing stop loss orders, are discussed extensively in Four Consistent Ways to Take Profits When Trading.
Every trade we take should provide us with more profit potential than we are risking. In this case, our risk was $1.30/share, but we were expecting to make about $4.20/share, plus dividends. Even when the trade didn’t quite work out as planned, we ended up making $1.7/share, plus $1/share in dividends.
In order to use this strategy, we need to find multiple good dividend stocks. “Good” means good price, good company, and good yield. The section below shows you how to find such stocks. You don’t need to find them all at once though. Only buy when good stocks are trading at the price you want. Over time you will accumulate a portfolio full of good dividend stocks purchased at a good price with upside potential.
How to Find Good Dividend Paying Stocks
There are thousands of dividend-paying stocks. We need to filter out most of these stocks so we’re only left with higher-yielding stocks which have decent volume (so we can get in and out of positions with ease) and that meet certain minimum criteria. When using a stock screener, such as Finviz.com (which is free to use), use the following criteria to find good dividend-paying stocks. Adjust the criteria to suit your personal goals.
- Click on Screener.
- Input Dividend Yield Over 5%.
- Average Volume Over 500K. This can be adjusted a bit lower to increase the number of stocks on the list.
- Price criteria over $5.
- IPO Date More than a year ago.
- Under the Industry drop-down, select Stocks Only or Exchange Traded Funds. Leave blank to see both stocks/REITs and ETFs that match your criteria.
- Under the “Fundamental” tab input personal filters based on the type of stocks you want to own.
- Consider including a Payout Ratio criteria less than 100%. Occasionally, this temporarily bumps above 100%…so consider using 110%, with the understanding that dividend payout cannot exceed earnings indefinitely.
- Price/Earnings greater than 0 (showing company has positive earnings).
- You may also opt to look for only stocks that are trading at low P/E levels, such as below 15 (but above 0).
- Operating Margin, over 10% (the company can likely pay its bills).
- Earnings per share are stable or rising over the last 5 years. Stocks with large consecutive earnings declines over the last several years should be avoided.
- The fundamental criteria help us avoid failing companies where the stock price just keeps dropping, even though at times it may look like a good deal.
- If you are looking for ETFs, some of these criteria will interfere with the search results. For example, including a Payout Ratio or Operating Margin criteria will block ETFs from showing up in the sceener results.
- View results in “Financial” mode by clicking on “Financial”.
- Click Dividend twice so the list is ranked from highest to lowest in terms of Dividend Yield.
- Change view to “Charts” mode (they are still ranked highest to lowest dividend yield).
- In chart mode, if a stock is trading near the high on the time frame (chart) shown, leave it alone. If a stock is trading near the low, it deserves a look.
- Manually go through the stocks on your list. Have your chart platform open (such as TradingView.com) and view a 5+ year chart of the stock. In order to consider it for purchase, it should be trading near a major support level over that time frame, as well as meet all the fundamental criteria.
Running the screener in January of 2018 produced a total list of less than 20 stocks. When checking those stocks for stable or rising earnings, the list is reduced to a handful. The following is an example of a stock that meets the criteria and is also heading toward a buy zone, indicating a possible future purchase…assuming all still looks good when the price reaches the entry point.
The stock has stable earnings of about $0.80/share over the last several years. The price has fluctuated between $6 and $9 with some regularity. Nearly all earnings are paid out in dividends. The ideal entry area is $6 to $5.50, providing a dividend yield of 13.3% ($0.80/$6) per year. A reasonable exit point, given the last several years of price action, is anywhere above $8.40, likely providing an additional 40% in capital gains if buying at $6. For this all to happen, the price needs to decline into the buy zone. If it doesn’t, there is no trade. All fundamentals of the stock much also still look good in order to the trade to be placed. For example, earnings should be stable or rising and the P/E should present similar value to what was provided on prior buying opportunities in the stock.
If earnings weaken by the time the price enters the buy zone, then we would want to consider buying near the 2008 support area instead.
The screener covers the bare minimum criteria to look at. There are definitely more criteria that can be added in if looking to only buy solid companies. For some books on investing and what to look for, check out Best Trading and Investing Books.
Dividend Stock Pitfalls
There is a risk that a company may stop paying their dividend or reduce it. Since the dividend can be an attractive feature to investors, a negative change in the dividend can also have a negative effect on the stock price…a double whammy. My experience has been that this is usually temporary. If the company is solid, reducing the dividend is short-term negative but long-term positive for the share price…IF the company is going to put that capital to better use within the company.
It is also possible a company may increase their dividend. This will have a positive effect on yield but may also affect the share price positively or negatively depending on the particular situation.
When doing your manual screen through the stocks, look for stocks where the company has a stable history of dividend payments. At first glance, a dividend yield may look great, but upon looking at the history you see that the most recent dividend was a one-time payment not likely to be repeated, or that the dividends are highly erratic and the good yield may not continue into the future. Consistency is good.
When screening for dividend stocks in this manner you are relying on third-party data providers that may not always be posting accurate information, or the information may be outdated. Before making any purchases make sure the data is accurate. Check multiple sources to make sure you are working off the correct information.
Summary: How to Find Good Dividend Stocks to Buy
Dividend stocks are great for passive investors and active traders alike. For investors, dividend stocks tend to produce better long-term returns than their non-dividend paying peers. For active traders like me, dividend stocks provide an alternate stream of income and put dormant capital to work.
Look for good dividend paying stocks with a good yield, that can also be bought at a good price based on the 5 to 10 year chart history. If you can’t get it at the price you want, wait, or look for another opportunity. New opportunities arise every few weeks and months as stock prices constantly fluctuate. Screen for stocks that meet your desired dividend criteria.
The dividend policy of companies may change over time, affecting both the yield and the price of the stock. These things happen. In the case of a negative event, move on and look for other opportunities. Always double-check that the financial information you receive from third-party vendors is accurate before acting on it.
There are many ways to invest. This is just one way. This strategy tends to find stable companies with good return potential. To find stocks with great return potential (the strong of the strong) typically requires looking at companies that are growing and therefore may not pay a dividend at all.
By Cory Mitchell, CMT