10/08/2015 08:15 EDT | Updated 10/08/2016 05:12 EDT

How to Pick the Right Dividend-Paying Stocks

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Dividend paying stocks can offer it all -- high current income and capital appreciation potential -- but only as long as you pick the right ones. Some are "stars," or cheaply priced stocks that represent high-quality companies with solid prospects. Others, though, are so-called "dogs," or stocks that are deceptively attractive but which represent low-quality companies with unsustainable dividends. The biggest challenge for investors is separating the quality companies from the dogs, which can result in a massive difference in your long-term returns.

Investing in dividend paying companies is a sound strategy and one that's liked by a lot of investors. In fact, research has shown that dividends have proven to be the primary source of real return for investors, making up over 80 percent of stock returns net of inflation. From a practical perspective, especially during these days of market volatility, dividends help create stability in equities returns. For those living off the portfolio income, dividend paying stocks allow investors to distinguish "income" from "principal" by spending dividends and leaving principal in the market.

We are at the onset of a rush over to dividend-paying stocks. Much of this is influenced by the aging demographic. As we get older, we want less risk and a steady stream of income, which are the main characteristics found in dividend-paying stocks. In the past, we might have looked to fixed-income investments, but in this low interest rate environment, that is not as an attractive option.

So, how do investors choose the best dividend stocks? Although the most obvious way is to look at current dividend yield, in my opinion, it's the worst way.

High dividend yields often mask problems within a company, such as poor growth prospects, high debt issues, or a failure to generate attractive profitability. It may not be obvious to the casual investor, but a higher yield can often signal the market's lack of confidence in the company's ability to maintain the current dividend rate.

We have seen plenty of companies lure investors in with juicy dividends, only to soon cut those dividends. Yellow Pages, Atlantic Power and AGF come to mind, as do many Canadian energy companies. When companies cut dividends their stock prices plunge, often resulting in capital loss multiples greater than the dividend yield themselves. If investors had focused on the underlying fundamental trends of these businesses, they would have avoided these losses.

Rather, investors should choose dividend-paying stocks by focusing on the quality and fundamental strength of a company, not its current dividend. Why? First, because it always makes sense to own good businesses that are fundamentally trending in the right direction. And second, because it's all about going for the win. The real strategy in winning with dividend stocks is simply by not losing -- avoiding the low quality companies.

At Purpose, our dividend funds assess quality by scoring companies on a number of fundamental questions, including trends in return on assets, profitability, liquidity, asset turnover, as well as debt and shares outstanding. Companies that have positive trends and therefore higher scores are what we deem quality companies because they are doing the things that good healthy companies do. Companies with low scores reveal the dogs, which we screen out and avoid like the plague.

The second differentiator we do is overlay a "sector diversification discipline," which means having a broad mix of holdings across multiple sectors. Sector-diversified portfolios do better through changing economic cycles and offer smoother long term experiences. This point is actually a real issue within dividend funds and dividend ETFs broadly; they are too often concentrated in a few sectors. In our opinion, sector diversification is just as important as company diversification. Don't let this point slide.

The main point we want to drive home is that when you're investing in dividend stocks, don't just simply buy a stock because it has a high yield. Build a portfolio that is focused on quality companies; those that are fundamentally getting better, not worse; and make sure you are properly diversified by sector.

Remember that with dividend stocks, the champions generally win by not losing.


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