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Among the problems many investors are facing today is a lack of income from their investments in this period of low yields. A possible strategy is to seek high-quality and high-payout stocks that bypass the turmoil on the financial markets and deliver attractive total returns in cash.
Large and safe dividends are traditionally found in areas without much cyclical exposure, such as utilities, defensive consumer goods, healthcare, telecom and energy. “These sectors have already been tested under stress and served investors well during the crash of 2008-09”, says Josh Peters, Morningstar’s Director of Equity-Income Strategy and author of The Ultimate Dividend Playbook. “I expect similar resilience going forward, and even in a low-growth, high-uncertainty economy, I think it is possible to find dividends that can grow faster than inflation.”
Dividend Drill
For Peters, the most important questions regarding dividend are: is the dividend safe, and will the dividend grow? Though there is no single definition for what creates a safe dividend, the answer lies in the payout ratio plus a margin of safety. The payout ratio is the amount of earnings paid out in dividends to shareholders and indicates what companies are doing with their earnings. A low payout ratio means that a company is primarily focused on retaining its earnings rather than paying out dividends. The payout ratio also indicates how well earnings support the dividend payments: all else being equal, the lower the ratio, the more secure the dividend because smaller dividends are easier to pay out than larger ones. However, companies with stable revenues and earnings are in a better position to pay out large dividends than cyclical or volatile ones.
The answer of what creates a growing dividend lies in the earnings growth plus payout ratio. While a company with a low payout ratio may be able to raise its dividend even without growth of earnings, over the long run it is per-share profit growth that typically drives an increasing dividend.
In Peters' strategy, the total return for the dividend investor is indicated by the initial dividend yield plus the future rate of dividend growth. Capital gains on the stock should correlate with dividend increases over the long run, with that correlation growing stronger over time. “I like to think in terms of a ‘Rule of 10%’”, states Peters. “Without dividend growth, very few stocks can yield enough to provide an adequate total return on current income alone. To earn 10% returns on a stock yielding 1%, you need an annual dividend growth of 9%, forever. A 6% yielding stock can return 10% with just 4% growth.”
Fundamental factors that are driving dividend increases are core growth of the business over time, profitability of internal growth, possibility of pricing power or built-in inflation hedges and capital allocation (that is, what happens to retained earnings). Low yields often result in poor correlations between the dividend and the share price, even if the dividend is growing. Super high yields can be too risky. “I focus on what I call the sweet spot, yields between 3-4% and 7-8%”, says Peters.
Click here for page 2, which lists dividend payers around the globe.
