Consistent Growth From Committed Companies

August 03, 2015 at 08:00 PM

Share & Print

It's hard to argue with $376 billion. That's the amount S&P 500 companies paid in dividends during the trailing-12-month period ending in January 2015, according to a recent FactSet "Dividend Quarterly" report.

It also was the fourth consecutive quarter in which the amount of dividends paid on a trailing-12-month basis reached a record high, FactSet notes. Over that period, dividends per share grew nearly 12%; six of the 10 S&P sectors reported double-digit increases, with 421 (84%) of S&P 500 companies paying a dividend.

Plus, payouts continued to move higher in the first half of 2015 (though at a slightly slower pace than previously), according to S&P Dow Jones Indices. This data set is broader than the S&P 500 and includes about 10,000 stocks traded in the United States. In addition, the group reported that dividend net increases (i.e., increases minus decreases) fell by roughly 10% to $49.5 billion for the 12 months ending June 2015 vs. an increase of $55.1 billion for the corresponding period in 2014.

However, for the year ending in June 2015, close to 3,100 companies increased their dividends, while only about 390 reduced them. It should be noted that dividend reductions were concentrated largely in energy stocks, as lower energy prices affected the cash flows of these companies.

The current dividend growth trend isn't limited to American companies. Global dividends reached a record $1.17 trillion in 2014, 10.5% higher than in 2013 on a headline basis (the change in total gross dividends). That was the fastest increase since 2011, according to the "Henderson Global Dividend Study" (or HGDS), released in February 2015.

This underlying dividend growth, which the company calculates by stripping out special dividends, currency movements, changes in the index and changes in the timing of big dividend payments, grew by almost 9%. The HGDS index reached 159.9 at the end of 2014, meaning that dividends paid have grown almost 60% in just five years.

The Case for Dividends

Several factors support the case for investing in dividend-paying stocks. These include competitive yields.

"In this extremely low interest rate environment, it's very hard to get yield," said Ari Sass, portfolio manager of the MD Sass Equity Income Plus Fund of New York. "And if you're going to get any reasonable amount of yield, you're probably taking a significant amount of interest rate risk.

"I don't know where interest rates are going, but I know at 2% (for the 10-year Treasury) the odds are that they're going up over time, not down. So, I think in a quest for yield, one would have to go pretty far out in duration and would take fairly substantial interest rate risk," Sass explained. "Dividend-paying stocks are an interesting alternative to bonds for those who want yield."

In a spring 2015 research report, "The Compelling Case for Dividend Stocks in 2015 and Beyond," Al Frank Asset Management (AFAM Capital) of Aliso Viejo, California, comes to a similar conclusion: "Considering that inflation has averaged 3% per annum over the past eight decades, those willing to accept the current yields on 10-, 20- and 30-year Treasuries are likely to see a reduction in purchasing power and little in the way of real return if they hold to maturity. And should they wish to cash out prior to 2025, 2035 and 2045, respectively, they risk capital losses."

Seeking higher yields in developed markets overseas isn't likely to pay off, either, the report adds, as rates in several of those markets have been even lower than their U.S. counterparts. Financial history also favors dividends, according to the AFAM Capital report.

Relative to Treasury bonds, the report notes, dividend yields "are about as attractive as they've been in more than 50 years. Aside from several months at the height of the '08-'09 Global Financial Crisis, the last time the yield on the S&P 500 was as close as it is today to the yield on the 10-year Treasury was 1958."

It's important to seek stocks with growing dividends, not just currently high yields, because dividend stocks without payout growth are like bonds, Sass cautions. "We're not interested in bond proxies," he said. "We're interested in dividend growers that would have much less interest rate risk than those that have dividends that are not growing."

Contribution to Total Return

Dividend income alone isn't a sufficient return for most investors, of course—the goal is to earn a total return comprised of dividends and capital appreciation. During bull markets, the contribution of dividends to total return is often modest. But from a long-term perspective, reinvested dividends contribute significantly to performance.

AFAM Capital's research provides an illustration from the last 10 years. On Dec. 31, 2004, the Dow Jones Industrial Average was 10,800. By Dec. 31, 2014, the index had advanced to 17,800, an increase of 7,000 points, or 65% for the period. When reinvested dividends are included, however, the index increased by 114% on a total return basis.

Dividend stocks' long-term relative performance holds up well, too. Using data compiled by professors Eugene Fama and Kenneth French, AFAM Capital calculated total returns for the period 1927-2014. "Dividend-paying stocks actually have delivered better long-term total return performance than non-dividend payers by a score of 10.4% per annum to 8.5% per annum from 1927-2014," the group stated.

"Dividends are an important part of total return. Historically, they've been a much greater percentage of total return. If you look over the past, say, 70 years or so, dividends have been as high as 50 to 70% of that total return when you include their cumulative impact plus capital appreciation," said Brian Campbell, a portfolio manager with the London Company and a sub-advisor of the Touchstone Large Cap Fund of Richmond, Virginia.

"Today, they're much, much less than that. Now, dividends are roughly less than 20% of the total return in the last five years," he added. "So, there's a strong case to be made that they will be a bigger influence going forward."

Dividends as Fiscal Discipline

Another important role for dividends is that they help hold corporate managers accountable for their financial decisions, says Campbell. The London Company's investment selection process involves finding companies that allocate capital well, because capital allocation is the most important aspect of a manager team, he adds.

Sound capital management practices include returning capital to shareholders, either through buybacks, dividends or investing in projects that earn returns above the company's cost of capital. "There are obviously advantages inherently involved with dividends," he said.

"First, those income streams are a steady state and hopefully a growing state of income. That somewhat handicaps manager teams that are poor capital allocators from doing anything silly, you know, doing any destructive acquisition or overinvesting in a project that's never going to earn a spread over the cost of that project. So, it does provide a little bit of discipline, and I think that's helpful," the portfolio manager explained.

"If you look at the S&P 500 today, more and more companies are paying dividends … 420 S&P 500 companies are now paying a dividend, and that's up from 350, 15 years ago," he noted. "So, the importance of dividends is being demanded by shareholders, and the discipline that it brings to manager teams is a positive for everyone involved."

Lower Volatility

Investing in firms with capital-allocation discipline like dividend payers also can provide a cushion in down markets, Campbell notes. "We build our portfolios with a very conservative approach," he said.

"They're typically lower beta, higher quality and when markets do turn south, we've had the tendency to hold up much better than the index by and large. Now, as a byproduct of our process, we also have a higher average yield than the index, so our experience has indicated this that has actually helped when markets turn south," the expert stated.

AFAM Capital's research supports that contention. Using historical data sets, the firm calculated the volatility of long-term returns for dividend and non-dividend stocks. "Dividend-paying stocks have enjoyed lower volatility as the standard deviation measure from 1927-2014 equals 18.3%, compared to 30.1% for non-dividend payers," according to its report.

The group concludes that dividend payers, "despite their strong return characteristics, have actually had meaningfully lower standard deviation."

That reduced volatility could benefit investors' future returns, Sass points out. Equity markets are in an extended bull market; using a baseball analogy, he compares it to being in the later innings of a recovery. Because dividend stocks tend to outperform in down markets, they can be attractive to investors who want equity exposure with potentially lower volatility.

"To the extent that someone wants equity exposure, … might be nervous about the prospects for the market, but [still] like it relative to, let's say, other asset classes like bonds, I think dividend payers tend to cushion the downside a little bit better than non-dividend paying stocks," he said.

Quality & Consistency

One proven method for identifying companies that consistently increase their dividend is to use a screening method like that developed for the Dividend Achievers. According to Mergent's "Handbook of Dividend Achievers," issued in the spring of 2015, publicly traded companies must meet multiple criteria to qualify for inclusion in the exclusive roster.

Those qualifications include trading on a major exchange and having a history of rising dividends for the last 10 or more consecutive years (five years for Canadian companies). The handbook's frequently asked questions points out that just over 10% of over 2,500 U.S.-listed, dividend-paying stocks qualify. The resulting roster is comprised of companies from nine industry sectors and more than 33 industries.

Making the cut is an impressive achievement, the handbook notes: "Dividend Achievers have demonstrated the ability to consistently increase dividend payments over a substantial period of time, through volatile markets and challenging political climates."

Nasdaq OMX acquired the Dividend Achievers brand from Mergent in late 2012. (Mergent is a leading provider of business and financial information on global publicly listed companies.)

The exchange has made multiple domestic and international indexes available for licensing under the Nasdaq Dividend Achievers trademark. The Nasdaq OMX website also discusses the value of dividends to investors in its "Why Dividends Matter" section, which includes the following highlights:

Companies that pay regular dividends tend to be in better financia health and produce sustained earnings and revenue growth.
Dividends help identify well-managed companies; every dividend declaration represents a promise by management and a vote of confidence by the board of directors in the company's leadership.

Corporate Commitment

Dividends don't occur in a vacuum. A company's board must decide how much, if anything, to distribute, based on the firm's ability to make and maintain the payment.

At Questar Corporation in Salt Lake City, Utah, for example, the firm monitors its dividend-payout target in light of business results, according to Tony Ivins, vice president, investor relations and corporate treasurer.

"Questar currently has a dividend payout target of 65%. This target was raised earlier this year from 60%, reflecting our company's strong cash flow generation and confidence in the ability to reward shareholders over the long term with both growth and yield. Questar has increased its dividend 43 times in the past 43 years, including an 11% earlier this year," Ivins explained.

"We recognize that it is important to maintain a dividend rate, yield and payout competitive with our peer companies. That said, management's first priority is to organically invest each of our integrated businesses to drive growth," he stated. "Our second priority is to maintain a competitive dividend."

Aqua America, Inc., of Bryn Mawr, Pennsylvania, also has a long history of paying dividends, according to President and CEO Christopher H. Franklin. The company has a stated payout ratio goal of 60 to 70% and has made consecutive quarterly dividend payments for the past 70 years with 24 increases in the last 23 years.

"As one of the largest publicly traded water and wastewater utility companies in the nation, serving eight states, Aqua invests needed capital to improve the country's aging infrastructure. We earn a fair, regulated return on those investments and then return some of that capital to our investors through our dividend," Franklin said.

"The company has adopted a growth-through-acquisition strategy where we look to purchase both privately owned and municipal water and wastewater systems where we can grow our customer base and make additional capital investments," the executive explained. "We see future success for this strategy, which should allow us to continue to be a leader in our industry when it comes to increasing dividends."

Last year marked the 60th-consecutive year of annual dividend increases for American States Water in San Dimas, California. "Our goal is to increase our dividend at a compound annual growth rate of 5% or more over the long term," said President & CEO Robert Sprowls.

"Our 2014 dividend-to-earnings payout ratio was approximately 54.3%, based on our current annualized dividend of $0.852 per share. This is below the average payout ratio for the U.S. water utility industry and, along with growth in our future earnings, allows us the opportunity to increase the dividend in the future," Sprowls explained.

"Consistent growth in earnings over the last 10 years at our utility subsidiary, Golden State Water Company, has been the driver behind American States' annual growth in the dividend over the last 10 years," the CEO stated. " We have been able to grow the dividend at a higher rate the last three or so years due to the significant earnings contribution from our contracted services subsidiary, American States Utility Services, Inc."

Keeping a Long-Term Perspective

No equity-investing strategy, including investing in dividend stocks, can guarantee results, of course. Returns on these stocks still correlate with overall market moves; they're also influenced by changes in interest rates and any reductions in dividends. Interest rate risk has weighed on the recent returns of utility stocks, which tend to have high dividend yields and payout ratios.

The S&P 500 Utilities sector was a top performer in 2014 with a 29% total return. Through mid-July 2015, though, the sector's total return was -10.7%, as market yields rose and the Federal Reserve reiterated its desire to increase rates in the near future.

But historical research indicates that stock market sell-offs from interest rate hikes are based on misperceptions, experts say. AFAM Capital, for instance, examined returns for the intervals around Fed tightenings since 1954.

"Indeed, stocks have actually gained ground for the full six months prior to the start of tighter Fed tightening on all but a couple of occasions. Same thing goes for 12 months after," the group explained in its analysis. "No doubt, there has been plenty of volatility surrounding major Fed moves, with sizable short-term losses sometimes suffered by those who can't stomach the fluctuations (which we are told was the gist of the S&P data), but those willing to remain patient have been rewarded more often than not."

Investors typically pummel a stock's price if they suspect a potential dividend cut. That risk makes dividend safety paramount for investors. Monitoring a stock's payout ratio provides a first line of defense, says Sass. His firm likes to see the payout ratio, using dividend per share divided by the free cash flow per share, under 75% or so. This level provides a margin of safety in free cash flow to cover the dividend, he explains.

"If you have a high dividend-payout ratio, there's clearly not a lot of room for error in the event of a downturn when the dividend could get cut," Sass explained. "So, free cash flow is really … the most important metric."

Other experts also emphasize the importance of strong financials to support a dividend. Businesses with high returns on capital generate free cash flow, points out the London Company's Campbell. That condition allows a company to self-fund its growth and return capital to shareholders through buybacks and dividends. Identifying companies with these characteristics reduces the risk of dividend cuts.

"So, for us, [a] focus on that universe eliminates a lot of the risk of companies overextending themselves, historically having to cut a dividend or, even worse, not being able to pay it and having a negative surprise," he said.

NOT FOR REPRINT