Eight straightforward rules define smart dividend investing

The potential of a reduction in quantitative easing by the Federal Reserve has lead value and income investors to be wary of future bond yields. Likewise, the extremely low CD rates have caused investors to begin exploring other avenues of attaining consistent interest rates while mitigating risk.

I have found that value based dividend investing can be a good strategy to cushion your portfolio while allowing you to balance risk while outperforming other more secure options. There are eight straightforward rules to dividend investing to meet these objectives:

What to buy

  1. Quality

Common Sense Idea: Invest in great businesses that have a proven long-term record of stability, growth and profitability. There is no reason to own a so-so business when you can own a great business for a very long time.

Financial Rule: Invest only in stocks with 25 or more years of payments without a reduction.

Evidence: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the Standard & Poor’s 500 index over the last 10 years by 2.88 percent per year.

  1. Bargain

Common Sense Idea: Invest in businesses that pay you the most dividends so you can increase your cash flow from your investments.

Financial Rule: Rank stocks by their dividend yield.

Evidence: The highest yielding quintile of stocks outperformed the lowest yielding quintile of stocks by 1.76 percent per year from 1928 through 2013.

  1. Safety

Common Sense Idea: If a business is paying out all their profits as dividends, they will have nothing left to grow the business. When a downturn in the business occurs, they will have to cut the dividend. Invest in businesses that have much higher profits than they do dividend payments so your dividend payments are secure.

Financial Rule: Rank stocks by their payout ratios.

Evidence: High yield low payout ratio stocks outperformed high yield high payout ratio stocks by 8.2 percent per year from 1990 to 2006.

  1. Growth

Common Sense Idea: Invest in businesses that have a history of solid growth. If a business has maintained a high growth rate for several years, they are likely to continue to do so. The more a business grows, the more profitable your investment will become.

Financial Rule: Rank stocks by long-term revenue growth.

Evidence: Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4 percent per year from 1972 to 2013.

  1. Peace of Mind

Common Sense Idea: Look for businesses that people invest in during recessions and times of panic. These businesses will have a relatively stable stock price that will make them easier to hold for the long run.

Financial Rule: Rank stocks by their long-term volatility.

Evidence: The Standard & Poor’s Low Volatility index outperformed the Standard & Poor’s 500 index by 2 percent per year for the 20 year period ending Sept. 30, 2011.

When to sell

  1. Overpriced

Common Sense Idea: If you are offered $500,000 for a $250,000 house, you take the money. It is the same with a stock. If you can sell a stock for much more than it is worth, you should. Take the money and reinvest it into businesses that pay higher dividends.

Financial Rule: Sell when the normalized P/E ratio is more than 40.

Evidence: The lowest decile of P/E stocks outperformed the highest decile by 9.02 percent per year from 1975 to 2010.

  1. Survival of the Fittest

Common Sense Idea: If a stock you own reduces its dividend, it is paying you less over time instead of more. This is the opposite of what should happen. You must admit the business has lost its safety and reinvest the proceeds of the sale into a more stable business.

Financial Rule: Sell when the dividend payment is reduced or eliminated.

Evidence: Stocks that reduced or eliminated their dividends had a zero percent return from 1972 through 2013.

Portfolio management

  1. Hedge Your Bets

Common Sense Idea: There are 10 stocks on your list each month. They are ranked in order. When you go to invest, buy the highest ranked stock of which you own the least of on the list. You will be spreading your bets over different businesses as time goes by. Better yet, you will still be investing in great businesses at fair or better prices.

Financial Rule: Buy the highest ranked stock of which you own the least.

Evidence: Ninety percent of the benefits of diversification come from owning just 12 to 18 stocks.

Umberto Fedeli is president and CEO of The Fedeli Group. He is an investor in numerous ventures and is on the boards of directors of the Cleveland Clinic Foundation, John Carroll University, the Cleveland Chapter of the Young Presidents’ Organization and The 50 Club.