Total-Return Investing: The Case Stays Strong

The first category was stocks that increased the trailing-12-month payout ratio; the second category held the trailing-12-month payout ratio steady; and the third group decreased the trailing-12-month payout ratio. Stocks in the first category outperformed the S&P 500 and other categories by a wide margin.

To produce such strong returns over time, companies have to carefully manage their financing. LTC Properties (LTC) in Westlake Village, Calif., for example, says that its financing strategy has been essential to its dividend policy.

According to Pam Kessler, executive vice-president and chief financial officer of the health-care REIT, low long-term bond rates have been very beneficial to the firm's growth and shareholders. "During 2012, we sold approximately $86 million in senior unsecured notes that bear interest at 5% and mature in 12 years," Kessler says.

"We used the proceeds to acquire long-term care properties at a generally accepted accounting principles, or GAAP, yield of approximately 10%. In turn, we increased the dividend in the third quarter from $0.145 per month to $0.155 per month. We target a funds available for distribution, or FAD, payout ratio of approximately 80%," she explained.

The result? Since 2003, LTC has grown its annual dividend from $0.65 to $1.79, which has produced a compound average growth rate, or CAGR, of 12.6%."Our current annualized dividend is $1.86 or $0.155 per month," shares Kessler.

Other companies cite a low cost of debt as a favorable factor in their dividend-related strategies, like Magellan Midstream Partners (MMP) in Tulsa. The firm, which transports, stores and distributes petroleum products, also notes that it takes precautions against higher rates that could reduce available cash flow. 

"As we set our dividend growth plans, we plan for higher interest rates and also make sure that we maintain adequate excess cash flow to cover us, if interest rates increase or if various other risks take shape," says Paula Farrell, director of investor relations, planning and reporting for Magellan. 

"We also maintain a very low amount of floating rate, near-term debt which lowers our exposure to increasing rates," explains Farrell. "With such attractive low rates, we are taking every opportunity to term out floating rate interest risks with longer-term (10 years or more) fixed-rate debt."

Producing consistence dividends also involves keeping a careful eye on a company's key businesses, along with growth and sustainability, experts say. "When selecting securities which we feel will produce growing distributions, we use a combination of financial ratios such as payout ratios, free cash flow, balance sheet and earnings trends, along with an understanding of the business mix," explains Gibbs.

For National Retail Properties (NNN) in Orlando, this means working to maximize the value of its existing property portfolio, keeping tight control of costs—especially debt costs—and acquiring properties that increase cash flow and allow for higher dividend payments, says CEO and Chairman Craig Macnab.

Changing Wisdom 

Josh Peters, CFA, editor of Morningstar's Dividend Investor newsletter in Chicago has methodically reviewed U.S. equity market returns of the past 100 years. He notes that the conventional wisdom of 9 to 10% long-run returns on equities "is in fact correct."

Over that period dividends have contributed roughly 4% of the total 9% to 10% returns. However, what's different today is that the dividend yield is only about 2.2 to 2.3%, even though dividends are growing. "That's steers you, I think, back in the direction of wanting to get those higher dividend yields now along with at least some growth that exceeds inflation." 

James Cunnane, managing director and portfolio manager at St. Louis-based FAMCO MLP, a division of Advisory Research, focuses on distribution, particularly within the energy-infrastructure field. In his view, a lower distribution with growth potential is typically a better investment than a higher distribution that is expected to be flat or worse declining.

Lower yielding investments with growth will trade more like equities, while higher yielding, low growth securities will trade more like fixed-income securities, says Cunnane. "We believe that equity-like investments will generate higher total returns in the slow growth, rising interest rate environment we are forecasting."

As Gibbs looks at areas that offer the potential to increase future dividends, he is bullish on technology thanks to its abundance of cash and strong fundamentals. In the last few years, he says, investor attention on dividends has caused many companies in the IT sector to initiate dividends or increase dividend payout ratios. 

"The sector has generated a lot of excess cash flow during this time frame, so it has the cash to continue to raise the dividends," says Gibbs. "Finally, many of the companies in the sector have a strong balance sheet, with many companies carrying large net cash positions. 

"This is important because technology is a cyclical sector. The cash balances will provide flexibility to maintain dividends should the economy turn down and earnings fall short of the dividend payment."

In addition, experts point out, investors aren't restricted to U.S.-based investment opportunities, of course. By expanding their horizons, investors can seek additional total-return opportunities that also add diversification to their portfolios. 

Ryan Brown, CFA, investment product specialist with MFS Investment Management in Boston, notes that "approximately 50% of the investable stock market universe is comprised of companies based outside the United States." 

Furthermore, as more U.S.-based firms do business overseas for growth-related reasons, the potential universe of total-return leaders is likely to expand both at home and abroad.