(09/13/12) What Makes a Great Income Stock

While many newcomers to the income sector would immediately say “yield,” that's not the case. To find a good long-term income stock, you have to look at a few other more important fundamentals before you get to the yield, writes Kelley Wright of Investment Quality Trends.

While yield is important—it is after all a measure of return on investment—it isn’t the end all be all of value identification.

What we have found is the best of the best are businesses that offer products and services that consumers want and need. They have management teams that demonstrate managerial competence over long periods of time. They have long-term track records of earnings and dividend improvements.

The percentage of earnings paid out in the form of dividends (the payout ratio) is sufficient to reward the shareholder while allowing the company flexibility to maintain and grow the business. Debt is managed and as used as a tool rather than as a crutch or a mask to cover up deficiencies or mistakes.

These companies are generally recognized as a leader in their field, a brand name if you will. For example, if you go to the store to buy soft drinks, bottled water, orange juice, or one of the new performance drinks, what company immediately comes to mind? My guess is it is either Coca-Cola (KO) or PepsiCo (PEP).

If you’ve got a mini-van full of hungry kids you have picked up from several different locations after a long day at work and the thought of going home and cooking makes your head spin, what more welcome site is there than the Golden Arches of McDonald’s (MCD)?

While buying a great company that is an easily recognized brand is important from the qualitative standpoint, your work as an analyst and investor is still only half done. The other half is the value proposition.

If you do everything right and then overpay for a stock, you increase your downside risk and reduce your upside potential. This is why it is critical to know the long-term repetitive dividend-yield patterns of great companies. Price is what you pay; value is what you receive.

One adjustment the investor seeking yield will often have to make is with their time horizon. Let’s use McDonald’s as an example again. When McDonald’s first hit our Undervalued area back in late 2002, the stock was trading in the mid-teens and the dividend was a paltry 19 cents per share—definitely nothing to write home about.

In fairly short order, though, as a result of a series of dividend increases, McDonald’s had achieved “G” stock status, our designation for outstanding dividend growth. Today, McDonald’s trades around $90 per share, and the dividend has increased to $2.80 per share.

Obviously, the investor who purchased McDonald’s in 2003 has enjoyed a wonderful capital gain. More importantly, though, particularly to the income investor, is that the dividend has increased over 1,000%. Now that’s a return on investment.

Thankfully, McDonald’s is not an isolated incident; I could compile quite a list if time and space were unlimited. What you need to understand is this: the potential for this type of return exists in the Undervalued category at any given time.

Obviously there is no guarantee every “G” stock will appreciate 400% or increase their dividend by 1,000%. The point is that this is a great place to look.

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