The secret to picking dividend stocks? A certain ratio

Looking to boost retirement income and to do so in a consistent manner? Think dividend-yielding stocks — but beware dividend traps. Shares that pay out dividends have a good probability of beating inflation, which is the biggest threat to fixed pools of money. They also allow clients to rely less on random capital gains as a way to pull income in retirement, said Charles Farrell, chief executive of Northstar Investment Advisors LLC. Mr. Farrell spoke on Monday at InvestmentNews' Retirement Income Summit in Chicago. “It's important to keep in mind that you need a different source of income,” he said, noting that dividend-paying stocks can provide investors with meaningful starting yields that are in the 3% to 3.5% range. And those payouts will grow in time. Indeed, while the share prices of dividend-yielding stocks do fluctuate, companies generally continue to operate and maintain their commitment to paying out dividends, Mr. Farrell said. Nonetheless, there have been major flameouts among dividend-paying companies. That's why it's so important for clients to beware of dividend traps, Mr. Farrell said. At the top of the list: slow-growing companies that are not diversified and that happen to also be high-yielding. Banks and real estate investment trusts fall into those categories, he noted. “We have very little in financials today,” he said. Instead, Mr. Farrell recommends that advisers aim for a starting dividend of 3% to 4%. He also advises placing your chips on an array of areas, including industrials, consumer staples, energy and materials. The two sectors with the largest price appreciation have been utilities and health care, Mr. Farrell said. He cautioned that in building a portfolio, advisers may have to give up yields in order to obtain real diversification. When assessing companies, Mr. Farrell referred to his dividend power ratio formula, which divides earnings growth by dividend growth. He aims for a ratio that's close to 1, signifying that earnings and dividends at a firm are growing at approximately at the same pace. A earnings/dividend ratio that's well above 1 suggests that the company isn't committed to paying out dividends that are commensurate to earnings. Meanwhile, a ratio that's too far below 1 shows the dividend payments are too generous and eventually will eat into earnings, Mr. Farrell said. Failure to analyze this “is why some dividend exchange-traded funds have difficulty,” he added. “They don't compare these [data]; you don't want a company that's paying dividends for the sake of putting out dividends.” Mr. Farrell warned that even though a dividend-paying strategy can provide an attractive income stream, investors should mind their bonds and avoid getting too aggressive in their fixed-income portfolios. “Fixed income is for defense,” he said. “Keep your bonds high-quality and take your risks with equities.”