How to Build a Strong Dividend Stock Portfolio for 2021

Companies that provide dividends increase their growth annually, a sign that the company expects to continue its profitability and can generate income to its shareholders.

Some companies still provide generous dividend yields even when their profit margins are low and they have large amounts of debt in an attempt to mask underperforming stock prices.

Investors can opt for mutual funds or exchange-traded funds that have a strong record of raising their dividends annually, which is an “indication that management has confidence in its prospects to continue to grow and still return cash to shareholders,” says Todd Rosenbluth, director of ETF and mutual fund research at CFRA, a financial research company in New York.

A generous dividend yield does not indicate that a company is managing its free cash flow well and is often up for debate. “However, investors will want to focus on higher-quality companies with strong balance sheets that are not just stretching to pay dividends but have the ability to do so with a cushion,” he says.

The economy continues to contract in the U.S. as the number of coronavirus cases rises. The Conference Board, a New York-based global think tank, estimates that economic recovery next year could be muted, at an annual expansion of 3.6%, based on “COVID-19 resurgence and any resulting lockdowns, the status of labor markets and household consumption, the size and timing of additional fiscal stimulus, the timing and availability of a COVID-19 vaccine and the degree to which volatility in the U.S. political transition affects consumer and business confidence.”

The yield provided by dividend-paying stocks is attractive to investors, but some storied, blue-chip companies either maintained or increased their yields despite facing anemic growth, historic losses in the second and third quarters, and stock prices that took a nosedive in the spring and have not rebounded. So income investors who want to build a dividend portfolio as the new year approaches should keep a few points in mind:

— Sectors that could perform well in 2021.

— Sectors to remain cautious of in 2021.

— How to invest in dividend-yielding companies.

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Sectors That Could Perform Well in 2021

Dividend-paying names tend to be established, blue-chip companies and can be categorized as defensive plays, says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.

“Investors on the hunt for yield are likely turning to these areas of the market for income,” he says.

The consumer staples, information technology and health care sectors have been safer areas to invest in 2020, Rosenbluth says. These sectors are less sensitive to the global economy, unlike consumer discretionary, energy and industrials.

Dividend-paying companies are a better alternative than investing in bonds because of their consistent cash flow payouts, says Robert Johnson, a finance professor at Creighton University in Omaha, Nebraska.

Dividend-paying stocks are an especially good strategy for adding income since bond payments are fixed and do not increase over time. The S&P 500 currently generates a dividend yield of 1.61%, while the yield on the 10-year Treasury note is less than 1%.

“For people looking for income, the bond market is unattractive and dividend-paying stocks provide an appealing alternative,” Johnson says. Utilities and financial stocks are generally good bets for investors looking for high dividend yields, he says.

Investors should not ignore consumer staples companies such as Coca-Cola (ticker: KO), 3M ( MMM), Genuine Parts ( GPC), Johnson & Johnson ( JNJ) and Procter & Gamble ( PG). Those companies have managed to raise their dividends every year for at least 50 straight years.

Dividend yield is calculated as annual dividends paid divided by the current stock price. Higher dividend yields can be the result of either dividends increasing or stock prices falling, Johnson says. “In fact, the very highest dividend-yielding stocks are likely stocks that have recently fallen precipitously in value,” he adds.

Many dividend yields that are elevated from lower stock prices often reflect a negative view that can make high-dividend-yielding stocks risky, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional.

“Evaluating the balance sheet debt and linking debt service to the expenses on the income statement can be an indicator of the remaining profits to sustain dividends,” she says. “The amount of leverage or debt and income used to service that debt will reduce earnings and will likely result in less profits to pay dividends.”

The percentage of public companies paying dividends has increased some large growth technology stocks initiating dividends, and other companies followed suit.

[SEE: Top 10 Dow Dividend Stocks to Buy Now.]

Sectors to Remain Cautious of in 2021

The energy sector produced the highest dividend yield increases, despite dozens of companies that filed for bankruptcy, since they were highly leveraged, crude oil prices sunk to historic lows and lackluster demand coupled with a global supply glut wiped out previous profit margins and tanked their stock prices.

Exxon Mobil Corp. ( XOM) continues to provide a dividend yield of 8% even though the global energy giant has $68.8 billion in debt, and its stock fell from a high of $71.37 to its current price of around $43.

Both Chevron Corp. ( CVX), which has a yield of 5.6%, and Exxon have prioritized dividends, unlike many of their European peers, and have cut operating expenses and capital expenditure costs to be able to fund their dividend payouts, says Bill McMahon, chief investment officer of active equity strategies at San Francisco-based Charles Schwab Investment Management.

“These types of companies have less flexibility when it comes to dividend coverage than other areas of the markets, but a lot depends on the level of oil and gas prices,” he says. “Both companies have attractive dividend yields, but investors should keep in mind their weaker coverage levels and hold the securities at the appropriate weight given their risk tolerance.”

High dividend yields do not mean the companies have good balance sheets and low debt levels.

“If a dividend yield is rising because the stock price is falling, that is a warning sign,” Johnson says. “The key for investors is to determine how likely that dividend will continue to be paid at the current level.”

General Electric’s ( GE) dividend policy demonstrates that providing an extremely high dividend yield and refusing to slash it can be detrimental. From 2008 through 2014, GE’s payout ratio was between 40% and 70%, he says. The payout ratio was more than 100% from 2015 to 2017, which was unsustainable.

Companies are loath to ever cut dividends since that is a very negative signal to the market, he explains. “When a company cuts a dividend, that is a strong signal to the market that the firm is experiencing financial difficulties,” Johnson says.

In November 2017, GE cut its dividend by 50%, which was the biggest all-time decrease on a dollar basis, he says.

“While GE didn’t completely eliminate its dividend, for all intents and purposes it did,” Johnson says. “In 1996, its annual dividend was $0.93 per share. Today, it is $0.04 per share.”

[Read: How to Live on Dividend Income.]

How to Invest In Dividend-Yielding Companies

Investors should choose companies that can continue to pay dividends in the future.

The Vanguard Dividend Appreciation ETF ( VIG) and the WisdomTree U.S. Quality Dividend Growth Fund ( DGRW) are a couple examples of dividend growth ETFs with strong reward potential and favorable risk profiles, Rosenbluth says.

The ProShares S&P 500 Dividend Aristocrats ETF ( NOBL) only holds stocks in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years and is a good addition to a portfolio, Johnson says. The equally weighted index has a dividend yield of 2.28%, an expense ratio of 0.35% and below-average risk compared to other funds in the large stock blend category.

While they’re largely considered safe investments, dividend-paying stocks are still subject to the ebbs and flows of the market, so funds like the Vanguard High Dividend Yield ETF ( VYM) and the Vanguard Dividend Appreciation ETF may be able to “capture the yield investors are looking for while smoothing out bumps in the road when it comes to return,” Loewengart says.

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How to Build a Strong Dividend Stock Portfolio for 2021 originally appeared on usnews.com

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