Thompson’s Note: Inflation has reached a 40-year high, the war in Europe is dragging on, lockdowns in China are pinching already stressed supply chains…

Regular readers know I’m not a macro guy—I’m a bottoms-up stock picker. But I still follow macro trends, and I can see the market stressors piling up. Which means SIC 2022 couldn’t be coming at a better time. We have an unparalleled roster of top-notch strategists lined up to guide you through the turmoil. And I’ll be there sharing more about how I find profitable opportunities in any environment, as well as answering your questions on the final day of the event. If you haven’t reserved your Virtual Pass to the SIC 2022 yet, take a moment and click here.

Now, let’s run through how to pick the best dividend-paying stocks, and look at my favorite one to buy now…

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Ask income investors what they’re looking for, and one word is bound to come up…

Predictability. Income investors want to know the money will keep showing up.

We all know stock prices fluctuate up and down. After all, nothing goes up in a straight line. But for strong dividend-paying companies, one thing remains constant: the cash they pay shareholders in the form of dividends.

This might sound obvious, but a company can only continue to pay dividends if it generates earnings. And it can only grow its dividend if it grows those earnings. With that in mind, here’s what I look for in a dividend-paying stock…

• First, look at cash flow, not earnings.

Traditional financial wisdom suggests using the “dividend coverage ratio” to evaluate if a company can continue to pay its dividends.

It’s a simple ratio: earnings per share/dividends per share. Meaning a company earning $1/share that pays a $0.25/share dividend can cover its dividend four times over.

It’s a reasonable metric. However, those earnings come from the company’s income statement. And they often don’t accurately reflect the cash moving in and out of the business. So, I look at something different.

When I’m evaluating a company’s dividend, I open its “statement of cash flows.” Then I’ll pinpoint its free cash flow (operating cash flow, less capital expenditures). And then I’ll scroll down a bit on the same statement and find “dividends to shareholders.”

• Rule of thumb: If free cash flow is greater than dividends to shareholders, you’re in good shape.

Consumer goods juggernaut Proctor & Gamble (PG) is a solid example here. P&G has generated a significant amount of cash flow after dividends over the past 5 years. Free cash flow has grown from $9 billion to $15 billion, while the dividend has grown from $7 billion to $8.2 billion. Meaning it’s had plenty of cash to cover its dividend.

•  The second factor I look at is the strength of the balance sheet.

If free cash flow is less than the dividend, the company is getting the money to pay that dividend somewhere. And most of the time, it’s from borrowing money.

Take oil major Exxon (XOM), for example. In 2020, it got itself into a precarious situation. Its free cash flow couldn’t cover its dividend to shareholders. The company managed to preserve the dividend, but not without taking on more debt. Its total debt rose 44% from $46 billion to $67 billion that year.

That is not a good sign. A strong dividend payer can maintain its financial strength while paying out its dividends from free cash flow. So, check the balance sheet to see if the company is increasing debt to cover its dividend.

• The third factor I consider is the quality of the business model.

A shrinking company is going to have trouble maintaining its dividend.

Take a company like Meredith Corp. (MDP), which sells print magazines and owns TV stations. Meredith was a strong dividend payer for years. But those are tricky markets—print magazines are dying off, and consumers are cutting the cord on cable TV. COVID exacerbated Meredith’s problems, and it wound up cutting its dividend during the pandemic.

• My favorite dividend-paying stock checks all three boxes…

In January, I shared three of my top picks for the year. One of them was AT&T (T). My editor begged me not to write about it when I first recommended it in Smart Money Monday. And I got the same feedback this go-around. “It’s too big, Thompson. You write about small caps.”

Sure, it’s not like the high-growth small caps I recommend in High Conviction Investor, but I still like AT&T a lot here.

As you may have heard, AT&T just finalized the spinoff of its Warner Media business and merged it with Discovery Communications. AT&T shareholders received 24 shares of the new company, Warner Bros. Discovery (WBD), for every 100 shares of AT&T they owned.

AT&T’s dividend is in great shape. The new company has a $1.11 per share dividend. On today’s price, that implies a 5.8% yield—one of the highest yields in the S&P 500.

The company has set a policy of paying out 40‒45% of free cash flow as a dividend. That’s a very healthy coverage ratio. It also gives AT&T flexibility to pay down debt if it chooses.

Historically, AT&T’s dividend has equaled 50‒65% of free cash flow. So, this new policy is much more conservative. Over time, it can return to slowly growing the dividend alongside earnings. And from an industry perspective, cell phones aren’t going anywhere, so we’re in good shape there.

AT&T checks all the boxes for a strong dividend-paying stock. Consider buying shares if you haven’t already.

Thanks for reading,

—Thompson Clark
Editor, Smart Money Monday

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