If you can remember back to the 1950s, not only was Elvis cool, but so were dividend-paying stocks. Investors bought them primarily for their yield. But as the years dragged on, and capital appreciation took center stage, they fell out of favor. They have regained some steam since the Nasdaq bubble burst in 2000, and favorable tax treatment in 2003 encouraged investors to take a fresh look. Yet one mystery remains: Given their strong performance track records, and other benefits they provide, why are they not even more popular now?
The numbers alone add up to a strong argument for seeking out dividend payers. The Dow Jones Select Dividend Index, which tracks the 100 highest dividend-paying public stocks, has overtaken the S&P 500 for the past three-, five and 10-year periods. And in recent years, several seminal studies have made measurable arguments for their longer-term track records. Last year, Ned Davis Research published a survey based on data from 1972 to 2005 that compared the results of S&P stocks that paid dividends with those that did not. Its remarkable findings demonstrated that over that entire period, dividend payers gained a respectable 10.1 percent per year, while those that shunned dividends rose a paltry 4.1 percent. Better yet, those that increased their dividends posted gains of 10.6 percent.
In their 2003 study, Clifford Asness and Robert Arnott discovered that dividend size also helps to predict corporate profits: The higher the dividend, the better the businesses performed over the subsequent 10 years. Their conclusions run counter to common wisdom, which might suggest that companies fare better by plowing earnings back into operations.
The meaning of dividends
Dividends serve as a signaling tool from corporate managers--the people who are assumed to have the best grasp of a company's current operations and potential. The dividend payers tend to be less cyclical and more consistent in their operating results. The declaration of a dividend payment indicates management's confidence in the future, especially as it realizes that it would send a dire message to the market to rescind it down the road. So a handsome payout demonstrates a measure of the company's current and future health and cash flows.
Signals matter because perception is always critical in investing; at the same time, dividends represent real cash that has been generated. Once that money is in the kitty, management has several options for deploying it. Aside from dividend payouts, they can make acquisitions, buy back shares, or reinvest the cash directly into new corporate projects.
Today's companies are being challenged to reinvest properly--either in new product development or in acquisitions that will prove accretive to earnings. Constant pressure from private equity puts corporations under pressure to optimize their balance sheets, and many have been turning to share buybacks. Whether these are positive or not, depends on whether management is cognizant of valuation. Unlike dividends, buybacks, are indeed tax deferred and, as one-off events, need not be repeated. But Hank Smith, CIO of equity investments at Philadelphia-based Haverford Trust Company, points to buybacks in the late 90s--particularly by Intel and IBM--as a "waste of shareholder capital." And buybacks structured to offset stock option issuance, he adds, are particularly questionable.
All companies experience a lifecycle. They must initially reinvest every dollar to build a platform for growth. "Once they become dominant in their industries, they reach scale and risk becoming bloated," says Don Schreiber, president and CEO of WBI Investments in Little Silver, N.J. "While they can find another smaller growth company to acquire, many executives forget it is not their money, and that they are fiduciaries for the shareholders. If they can't reinvest effectively, they should be returning it to them," Schreiber adds.
Moreover, after companies commit to payouts, any remaining funds are likely to be reinvested with more capital discipline. "If you only have 50 cents of every dollar left to invest, you will probably direct it to your optimal ideas," says Jill Evans, portfolio manager of the Alpine Dynamic Dividend Fund in Purchase, N.Y. With 100 cents available, it may be harder to achieve the best return on investment. The final investment decisions are most likely to be marginal--or even disastrous.
Driving the Trend
Tax law developments over the past four years have made the case for dividends even more compelling. In 2003, the Jobs and Growth Tax Relief Reconciliation Act sliced taxes on dividends from ordinary income tax rates to 15 percent. "For the first time ever, dividends and capital gains are taxed at the same rate, so CEOs should be agnostic as to which they pay," says Evans.
Capital gains are viewed as a rich man's tax, whereas dividends are associated traditionally with widows and orphans. "Politicians will have a hard time returning dividends to ordinary income rates, because a larger population of retirees is now dependent on the income," notes Dan Genter, CEO of RNC Genter Capital Management in Los Angeles.
The baby boomer bubble has become a retirement bubble. By 2020, 45 percent of the U.S. population will be between the ages of 55 and 57. "While inflation is still low at the moment, retirees are particularly vulnerable to the service element inflation, such as dining out, travel and healthcare," Genter points out.
The pension environment also has changed. In previous generations, corporations controlled the longer-term decisions through defined benefit pension plans. Now, control has shifted dramatically, as employers change over to defined contribution plans which means employees are more influenced by personal circumstances and interpretations of risk.
Where can they turn for income, since they need predictable cash withdrawals? Says Gentner: "They learned in the late 1990s that equities are not always positive or linear." The other income options are bonds and annuities. Most annuities do not offer inflation protection--at least not at a reasonable value--and they are not liquid. Bonds, unlike annuities, do provide liquidity, but today's yields are low. Dividend-paying stocks, however, can offer a high degree of certainty in both growth and income.
Picking and Choosing
The universe of dividend payers is a broad one. It represents almost all industries, with exceptions among early stage technology firms which are more often users than generators of capital. Fortunately, many dividend companies are among the ranks of the blue chip multinationals. Smith, who sees these corporations as a way of playing both developed and emerging markets, buys both ADRs and U.S. large caps for his clients. "Can these giants get even bigger? Absolutely," he says "As emerging markets achieve purchasing power, a developing middle class will buy their products, which we take for granted."
Investors approaching the wide range of dividend candidates must discriminate by various features such as dividend levels and growth history, cash flow coverage ratio and underlying fundamentals--including the health of the bonds and stocks. As a starting point, most analysts consider the payout ratio--the percentage of earnings paid out to shareholders. Payout ratios--which have averaged from 58 percent in the 1940s though 56 percent in the 60s, to 50 percent in the 1990s--are now reaching historical lows. By 2005, the ratio for the S&P had sunk to 31 percent, and it now scrapes 27 percent. Dividend growth has simply not kept up with earnings growth; hence the decline.
When Genter builds his portfolio of dividend superstars, he subjects his list of potential candidates to three screens, looking for integrity and commitment to the payouts. The initial screen examines the level of the dividend itself, which calls for at least 2.5 percent. Genter seeks a payout ratio below 60 percent (maintaining his average portfolio ratio well below 50 percent), and he establishes that there have been no cuts over the past five years. The dividends should be increasing at about 8 percent per year.
In general, if the ratio is too high, it would mean the company is squeezing out every last nickel to pay the shareholders That means that (1) it may have to cut the dividend eventually, and (2) it may not be plowing back quite enough into the company, so managers often look for a stock that has some room for raising its dividend.
Genter's second screen scrutinizes bonds. Since dividends are subordinate to bonds, it is critical to secure the sanctity of income flow. Underlying debt must be investment grade, reflecting no downgrades or inclusion on a negative watch list. "Management must not cut the dividend the first time they hit a pothole," Genter explains. "It should only be the last resort."
Finally, Genter analyzes the stock. Would he still be comfortable owning it, even if there were no dividend? Ultimately, his process, whittles his examination of all U.S. companies and ADRs listed on major exchanges down to a list of about 31 names.
The limitation of screens is that they are historical; actual investment is forward looking. Don Taylor, who runs the Franklin Rising Dividends Fund from Fort Lee, N.J., keeps a steady lookout for companies that might not be able to sustain their payouts. "Perfect screening candidates may be at risk, if they run into fundamental problems," he warns.
In any case, Taylor winnows his favorites through five screens. He requires a dividend increase for eight out of 10 years and a doubling over 10 years, which would be at least 7.3 percent compound annual growth. His payout ratio should be under 65 percent, "which," he notes, "is not much constraint in this environment."
Managing Expectations
Setting appropriate expectations for clients means educating them to the importance of risk management. Since dividend stocks tend to be less volatile during market downturns, they can play an important role in reducing risk. During the late 1990s, many investors lost sight of the risk/reward balance in their quest for the highest returns. "We knew the party would end, and we took some flack during that period. We lost a couple of clients who demanded 30 percent returns, while our dividend strategies were yielding about half of that," Schreiber reports. Those clients, sadly, committed financial suicide by jumping into speculative, doomed stocks at the end of the bull cycle.
Other advisors typically fight a similar battle. As Schreiber describes it, "clients really want a 20 percent CD, which of course doesn't exist!" It is the measure of a good advisor to help clients stay comfortably invested at the risk level they are willing to tolerate. Schreiber begins by the most important question on his policy statement: How much risk, and how many dollars are you willing to lose before you abandon a policy? Beyond a 20 percent loss, few clients are willing to stay the course.
A dividend strategy helps to focus investors on the longer horizon and away from near-term fluctuations. If they look at a company's ability to grow earnings, a pattern of steady dividend increases should provide a basis for future comfort. It is a defense against the natural reaction to sell on every dip, when confidence sometimes wavers.
Planners must also steer their clients from the risk of an overemphasis on current yield. There is a marked difference between a high dividend and a rising dividend strategy. Investors who are drawn to individual securities with high yields may also compound their mistakes with insufficient diversification. An overly high dividend can indicate weakness and deterioration. "Sometimes you can successfully pick turnaround situations among out-of-favor companies, but high yield should not be your clue," Taylor cautions.
Meanwhile, the entire dividend sector has prospered--independent of specific stock selection. The power of total return, which comprises both current income and capital appreciation, is beating all the major indices. Indeed, looking back, since 1926 dividends have made up approximately 35 percent of total return. "The story goes on," says Genter, "even when it flies below the radar."
Patience is Rewarded
The dividend history of General Electric provides a telling picture. Hank Smith uses it as a snapshot to illustrate the results of dividend growth for his investors. His firm, Haverford Trust in Philadelphia, has owned GE since its own inception in 1979. In that year, an investor would not have been particularly attracted by the 5 percent dividend the conglomerate was then paying. "Back then, you could have bought a U.S. Treasury yielding over twice that amount," Smith reminds. However, patience would be rewarded. By 1988, the investor would have received 12 percent of his original investment in dividends, and by 1998, a grand 42 percent of the initial investment. Most recently, by 2007, 114 percent of the original outlay would be returning in the form of income.
Vanessa Drucker, who used to practice law on Wall Street, wrote about contrarian investing in September.
