Here's How to Find the Best Dividend Stocks

Most income-seeking investors get too caught up in a stock's current yield instead of focusing on the metrics that matter more, like whether a company can sustain that payout over the long term. However, even if a high-yield dividend stock can maintain its current level, that will likely only earn investors a fixed income stream that they might have been able to get from a lower-risk investment like a bond. That's why they should take things a step further by looking at whether a company can increase its income stream on a consistent basis, since dividend growth stocks have historically produced market-beating returns.

Digging into the data

Companies that pay a dividend have historically outperformed the S&P 500. Using data from the start of 1972 through the end of 2017, dividend-paying stocks within the S&P 500 have delivered total annual returns of 9.25% compared to 7.7% for the index overall, according to an analysis by Ned Davis Research. However, just paying a dividend wasn't the deciding factor. What separated the winners from the losers was whether a company either initiated a dividend or increased it on a consistent basis. Those stocks outperformed all others by a wide margin:

As that table shows, while companies that maintained their dividends came close to producing market-matching returns, dividend growth stocks beat their stingier peers hands down. That's why investors should focus their attention on those companies.

The characteristics of a great dividend growth stock

The best dividend growth stocks tend to share four traits:

  • They generate lots of excess cash flow.
  • They have a strong, investment-grade balance sheet with solid credit metrics for their sector.
  • They have a healthy dividend payout ratio, which varies by industry.
  • They have visible growth prospects, which improve the probability that they can continue expanding cash flow and their dividend for years to come.

One company that has embodied these qualities is Magellan Midstream Partners (NYSE: MMP). That's why the midstream master limited partnership (MLP) has been able to increase its distribution to investors 66 times since its initial public offering (IPO) in 2001, growing its payout at a 12% compound annual rate over that time frame. That fast-paced growth has enabled the company to generate a total return of 2,610% since its IPO, which has vastly outperformed the S&P 500's 179.5% total return over that time frame.

Magellan appears well-positioned to continue growing its payout over the next several years. For starters, the company produces gobs of free cash flow. The pipeline and storage company currently expects to generate $1.12 billion in excess cash flow this year, backed by the fees it collects as customers transport and store oil, gasoline, and diesel across its midstream network.

Meanwhile, Magellan Midstream Partners boasts a top-tier balance sheet, as it has the strongest credit rating among MLPs. The company backs that up with a conservative leverage ratio of less than three times debt to EBITDA, well below its target of four times, which is the comfort level of most MLPs. The company also has a solid distribution coverage level of more than 1.2 times, which is a historically conservative level for an MLP.

Finally, Magellan Midstream has visible growth prospects. The company currently has $2.5 billion of expansions under construction, including a major oil pipeline and a marine storage and export terminal. These projects should grow Magellan's cash flow by about 5% to 8% per year through 2020, which should enable the company to increase its distribution at a similar annual pace. Meanwhile, the company has more than $500 million of expansion projects in development that could enable it to continue growing. Moreover, the industry needs to invest an estimated $321 billion in expanding its oil infrastructure over the coming years, which means Magellan should have plenty of opportunities to continue growing.

It's all about finding sustainable growth

While higher yields might be tempting, the best dividend stocks are those that increase their payout on a consistent basis. That's why investors should look past the dividend yield and focus their attention on companies that have the traits needed to deliver steady dividend growth. That pursuit should enable investors to build up more wealth over the long term.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool recommends Magellan Midstream Partners. The Motley Fool has a disclosure policy.