So the economy has (hopefully) bottomed out and is finally starting to stage a recovery. The recovery is already well entrenched on the stock markets, with stocks up some 60% from their 2009 lows. But there's no doubt that the future is uncertain. The economy just might not be able to post the kind of growth in the next five to 10 years that it's had in the five to 10 prior to the recession taking hold. We certainly can't borrow our way into prosperity the way that we have in the past.
This has implications for numerous aspects of the economy, but is particularly pertinent for long-term investors, who are currently contending with an environment of record low interest rates, high inflation and the prospect of muted economic growth. With equity performances have staged an impressive come-back over the past two years, it would seem prudent to expect that similar performances are perhaps unrealistic over the next two years and governments knuckle down to get public balance sheets under control. But muted equity returns only tell part of the story. Rather than splitting your view of investment opportunities into growth and income, we’re big fans of a total return approach.
Total return does exactly what it says on the tin: it’s a big picture approach, the total amount of profit or loss that you can expect from owning a stock or any other investment over a period of time. Rather than looking solely at the stock price or capital gains and losses, total return also takes into account the income—the dividend income or interest income—that an investment provides you.
Dividend yield tends to be much more reliable than price performance. Unless a dividend gets cut or suspended, it's always going be a positive figure: you never have to give a dividend back.
Even though the market overall has a relatively low yield at present, many individual dividends are above average and can provide anything between 3% and 8%. But dividend investors shouldn’t ignore growth when considering the total returns or what types of businesses they might want to own. Few stocks can provide a good total return on yield alone. To do that you might have to have a stock with a 9%, 10%, or 11% yield. And as the last downturn showed, those really aren't sustainable.
So what we want to think about is what kind of businesses can generate growth and a good income for shareholders, even in a low growth environment? Here's a couple of things to look for.
First of all, don't assume that growth has to come from a fast-growing business. Just because a business might only grow at, say, the rate of inflation: 2%, 3%, 4% a year over time--doesn't mean that it can't still provide a good total return.
For example, consider a business that has a 7% dividend yield up front, like perhaps some utility companies might have, or a real estate investment trust. If that business generates a 7% yield, you only need perhaps 3% or 4% of income growth in order to make a stock like that worth owning.
Now what about another type of slow growing business, perhaps one that doesn't have such a high yield? Clorox is a good example here. Over the previous decade Clorox only grew its business as measured by operating profit by only 3% or 3.5% a year. Yet earnings per share, and more importantly, dividends per share, rose at an almost 10% annual clip. The difference here is that even though the business only grew at a modest pace, the company generated so much cash flow, cash flow in excess of what it needed to reinvest in the business, that it wasn't able to just pay a dividend, it was also able to go back and repurchase almost 100 million shares of its own stock. And with fewer shares outstanding, that little bit of growth of the business overall turned into a lot of growth on a per share basis.
So if you're looking forward, don't think that you need a fast-growing business in order to generate a high total return. Dividend yield puts you on a firmer footing, can step your total return up into better territory. A business that has a modest growth rate can compensate you with having a good dividend yield upfront.
And even if the yield is a bit more modest, like the one I mentioned from Clorox, if the company allocates its free cash flow effectively, if it's disciplined in how it invests in the business, manages its balance sheet carefully, and deploys those pounds to maximum shareholder benefit, you can still get a good total return from a slow-growing business. And that's something I want to look for in a slow-growing economy.
This version has been edited and partly re-written by Holly Cook, Editor of Morningstar.co.uk, from an article originally published on Morningstar.com in September 2009 by Josh Peters, Editor of Morningstar.com's DividendInvestor magazine.
