How to cherry-pick the very best dividend stocks and avoid the losers

There is one cardinal rule of thumb when it comes to picking the best dividend stocks to add to your portfolio: if it looks too good to be true it probably is.

It’s a simple rule, but one which is essential to remember when faced with the sight of a 7% plus dividend. The simple fact is that not all dividends are created equal, so here is how to cherry-pick the very best dividends for your portfolio, while avoiding the losers.

Boring is best

First, check that there is nothing ‘special’ about the dividends paid in the last 12 months. Some companies like Woodside Petroleum Limited (ASX: WPL) and Coca Cola Amatil Ltd (ASX: CCL) have histories of paying ‘special’ dividends which are often not repeated in years to come.

Special dividends can come from companies distributing excess cash to investors, but this can skew dividend yield calculations on some websites. You want to base your decision on the likely future payments so be sure to ignore ‘special’ dividends.

Check the share price

A high dividend yield is often the result of a falling share price. This could indicate that the market expects lower earnings in the future in which case the dividend may be reduced or cut altogether.

Many resource companies, resource service companies, and retailers currently fall into this category. Myer Holdings Ltd (ASX: MYR) is a good retail example with shares falling by 20% in the last six months on investor uncertainty.

Similarly New Zealand telecommunication infrastructure business Chorus Ltd (ASX: CNU) shows on some websites as offering an 8.6% dividend yield, yet the company withdrew its dividend guidance in November last year amid ongoing regulatory issues and is yet to reinstate it.

Growth matters too

The ideal dividend company will have long-term growth prospects to ensure the dividends keep growing. Companies like FlexiGroup Limited (ASX: FXL) and Telstra Corporation Ltd (ASX: TLS) are both likely to sustain business growth over the long term, which makes their dividends of higher quality.

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Motley Fool contributor Regan Pearson owns shares in Flexigroup Limited

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