The Key to Smart Dividend Investing

Ask most income-seeking investors what they like best about dividend stocks, and they’ll tell you the obvious answer: their current yield. But if you want to be a smarter long-term dividend investor, you have to go beyond current yields to learn the secret of dividend longevity — in order to make sure those payouts will keep coming year after year, decade after decade.

Looking for immediate gratification
It’s easy to understand, though, why so many investors look first at how much income a stock will pay them right now. It’s really difficult to find good sources of investment income outside the dividend-stock arena, as interest rates on bonds and other fixed-income investments are near rock-bottom levels.

By contrast, the right dividend payers provide a goldmine of income right now. Want yields of 20% or more? American Capital Agency and Invesco Mortgage will get you there, while similar mortgage REITs like ARMOUR Residential come reasonably close. And even beyond the super-leveraged world of mortgage investments, you can find plenty of other stocks with double-digit yields.

With so much money on the table right now, it’s tempting just to grab it while it lasts. After all, a bird in hand is worth two in the bush, right? But over the long run, there’s more to smart dividend investing than just choosing the highest yields.

A true long-term yield
If you’re a dividend investor who’s in it for the long haul, what your stock pays you today isn’t nearly as important as what it’ll pay you in the years to come. While today’s highest-yielding investments may turn into tomorrow’s dividend busts, some lower-paying dividend stocks hold the key to huge future riches.

One concept that my Foolish colleague Selena Maranjian likes to consider is effective yield, by which she means the dividend yield measured by referring to your original purchase price for shares. Even if a stock carries a modest yield when you buy it, rapid dividend growth can boost your effective yield very quickly, making it much more attractive.

For instance, look at McDonald’s. Five years ago, it paid an annual dividend of $1 per share, and with shares trading in the low $40s, investors got a fair but not jaw-dropping dividend yield of around 2.5%. Since then, though, the company has raised its payouts every year, with the most recent hike pushing the annual dividend rate to $2.80. At today’s share price above $90, that still represents only a 3% current yield. But if you look at Selena’s effective yields, $2.80 on an original purchase price just above $40 equates to almost 7%. And what’s better is that today’s dividend looks just as sustainable as the payout did back in 2006.

Sometimes, falling share prices help you out by boosting yields. You can see that phenomenon in other high-growth dividend stocks. Lowe’s paid far less than a 1% yield in 2006, but dividend growth and a falling share price have combined to boost its current yield well above 2%. Walgreen had a similarly low payout rate, yet today it yields close to 3%. And despite Aflac suffering share-price stagnation, its yield has risen from less than 1.5% five years ago to more than 3% today.

By contrast, some past high-flying dividend stocks have fallen back to earth in a way that really hurt shareholders. World Wrestling Entertainment, for instance, cut its dividend by two-thirds earlier this year. After years of maintaining a dividend that equated to double-digit yields, the cut leaves investors with just a 5% payout — and that on a share price that’s roughly half what it was in early 2008.

Take a longer view
It’s easy to let those high yields tempt you into being short-sighted with your dividend investing. But for most investors, it’s just as important to keep dividends coming far into the future as it is to reap rewards right now. If you keep your eye on your long-run goals, you’ll find stocks that are better equipped to take you there.

Dividend investors have to focus on finding the best stocks they can. Let The Motley Fool get you started with its latest special report, in which you’ll find 11 strong dividend stocks with rock-solid businesses behind them. Click here to start reading about these stocks before everyone else finds out about them.

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