“Safety is something that happens between your ears, not something you hold in your hands.” – Jeff Cooper

Six easy-to-follow rules are the only thing that stands between you and hitting the income jackpot. Follow these rules and it’s almost impossible not to get at least 12 percent in total annual returns. I know, because that’s the minimum return I get when I recommend companies for my INCOME, portfolio.

What makes 12 percent so satisfying is that these are just about the safest investments around… as long as you buy right. And there isn’t a better time than right now to learn how to buy right. Why? Because dividend yields are at historical lows and they’re ready to go up. And even though dividends are at such low levels, getting income plus stock appreciation is such a sweet deal that investors aren’t shying away from them. They love the checks these companies send in the mail.

But whether they know it or not, these checks used to be a lot bigger when compared to market cap and earnings. Even though dividends are getting bigger, companies are growing at an even faster pace.

As earnings slow (and I think they will for the market as a whole), dividend yields are bound to grow. That means companies will be giving out more of their earnings as dividends. But nowadays, they’re hoarding cash for these reasons:

  • To buy back their own stock. It’s a case of supply and demand. When the supply of shares goes down, prices go up. It’s another way for companies to make shares more valuable for their shareholders.

There’s nothing wrong with that, except that your increased returns comes from capital appreciation. And to get the money, you have to sell the stock, as opposed to getting the increased returns through dividends that come every quarter in the form of bigger checks.

Most shareholders prefer getting the cash, and I don’t blame them. What’s more, stock appreciation can be reversed. But once the company sends you a check, nobody will knock on your door and take it back.

  • To reinvest in the company. Internal growth requires expanding assets. Growing companies need to get bigger physically – more equipment, bigger facilities, an expanded sales force, etc.
  • To buy other companies. Another way to expand that’s faster than internal growth.
  • To pay off debt. This helps the balance sheet.

But keeping so much cash in the coffers and not reinvesting it back into the company suggests a fundamental lack of faith in the company’s ability to grow and to get an adequate return on capital expenditures.

Of course, the company would put it differently. They’d pin their reluctance to spend on externals, such as economic uncertainty.

Unfortunately, this ends up becoming a self-fulfilling prophecy. The company’s growth consequently slows down, and when enough companies hoard (as they’re doing now), it stunts the growth of the economy. Then companies can point to a slowing economy as a reason not to spend.

The last thing you want, however, is to get bigger yields through share prices going down. You need to approach these dividends as a bonus. Look for fundamentally strong, attractively priced companies that also happen to pay dividends. This is how you do it:

1. Do not exchange income for value. Even when the market is expensive and most companies are overpriced, there are always stocks to be found at discounted prices. Dividend-paying companies are no exception. These companies have proven to be much hardier than other companies. They grow when the market is going up, and usually do much better than other companies when the market declines. Dividend plus value offers double protection against a falling market.

2. Look at payout ratios. These ratios tell what proportion of earnings is going out as dividends. There’s no hard-and-fast number I could give you, however. The historical average is 55 percent. Last year, the average ratio was 21 percent. (Remember, companies are hoarding, so this is not surprising.)

We want companies that have the ability to give out dividends and grow. So we like companies that give out a generous portion of their earnings to shareholders, but not so much that they strangle growth.

The higher a company’s dividend yield is, the more likely it is for its payout ratio to also be on the high side. A high payout ratio and a low dividend yield tells you you’re looking at a loser. Avoid it at all costs.

It’s worth doing some comparison shopping by looking up the payout ratios of a company’s competitors. Your company’s payout ratio should be lower or in the same range.

3. Do not settle for a dividend yield of less than four percent. There’s no complicated mathematical formula at work here. From experience, I can tell you that there’s not enough choice at five percent and above, and that there are too many companies with dividend yields below four percent to settle for such yields.

4. Look for at least 10 quarters of uninterrupted dividend growth. You want your dividend checks to be getting bigger, not smaller. And you don’t want to take the company’s word for it. You want evidence that the company is capable of sustained dividend growth. Past payout growth is no guarantee that the company will continue along that path, but at least they’re not blowing smoke. A record of dividend growth plus a solid growth plan executed by experienced leadership lays the groundwork for continued dividend growth.

5. Confirm past price performance. Seeing is believing, and you want to see that the company is already climbing up the charts. As I said before, past performance is no guarantee, but it sure beats the alternative – investing in a company that has been falling. That’s one way to attain an impressive dividend yield, but it’s certainly not the right way.

6. Catch the stock on a dip. Though dividend companies tend to be less volatile, it’s still worth buying them on the dips. Doing so could improve your return by 5-7 percent. Multiply that by several stocks, and it can make a big difference.

Is it really this easy? Yes and no. There are always surprises, like when the Canadian government decided to propose withdrawing the tax advantages for Canadian trusts. Those stocks immediately went into a dive, and have since experienced several aborted rebounds. But instead of getting out along with everybody else when the Canadian REIT in our INCOME portfolio dived, we waited and issued “sell” instructions to our subscribers at the top of the first of the company’s several rebounds – with only a slight loss in our portfolio to show for it.

Payout ratios are the trickiest thing to figure out. So let me give you a simpler rule to follow: Anything under 55 percent is fine. If the payout ratio is more than 55 percent, do the following. If it’s gone up over the past six quarters, don’t invest. If it’s gone down, consider it a green light to buy.

There’s one more thing you need to keep in mind: Finding fundamentally strong companies – whether or not they pay dividends – requires serious digging. There are no shortcuts to doing the work. If you don’t have the time, get a trading service to help you out. The good ones should be able to find exceptional dividend-paying companies for you.

For example, one of the biggest gainers in my INCOME, portfolio is a pipeline company I recommended last July. It’s up almost 50 percent… and I consider it the safest stock in my portfolio.

It just goes to show that with dividend-paying companies, you don’t have to choose between great returns and safety. You can get both. Can you ask for anything more than that?

[Ed. Note: Andrew Gordon, ETR’s Investment Director, author of several books on energy markets, global countertrade practices, and the hot growth sectors of China and Russia, is the editor of INCOME, a monthly financial advisory service that uncovers income-generating stocks that promise safety (first and foremost), along with much-higher-than-average profit potential.]

Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn't traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.