Depending on the latest European crisis report or economic signals from China, the U.S. markets have been gyrating between risk-on and risk-off days. If your clients are tired of getting battered by headline risk, it might be time to focus on total-return investing.
Total-return investing — seeking a combination of current income plus capital appreciation — isn’t a new strategy, of course. In general, its popularity tends to vary inversely with stocks’ performance and the level of interest rates: Bull markets and attractive fixed-income yields can dampen investors’ interest.
It’s been that way for years, says Tom Huber, portfolio manager of the T. Rowe Price Dividend Growth Fund (PRDGX) in Baltimore, Md. “If you take a little longer-term view, dividends really fell out of favor in the 1990s as the market was compounding at 20 percent-plus kind of rates for many years at a time,” he says. “So the idea of dividends as an important component of total return sort of fell off the grid for investors. That 2 to 3 percent that you could pick up from dividends wasn’t really relevant,” Huber explains.
The weak capital gains in the overall stock market for much of the past decade, combined with the current volatility, has made dividends and total-return investing much more attractive today, however. In addition, income investors face low yields on fixed-income investments. “The idea of fleeing to bonds or to cash for safety and at least a little income, I mean, honestly, there’s not a whole lot of income there anymore,” says Josh Peters, CFA, equities strategist and editor of the “Morningstar Dividend Investor” newsletter.
Buying dividend stocks, however, should be seen in a broader context, Peters argues. “The fact of the matter is that over long periods of time, most of us are in it for the long haul,” he says. “Dividends become more and more important to driving the overall results of your portfolio to the point where, if you go back over the last 100 years in the U.S. stock market, you would find that more than 80 percent of the total return is explained by dividends and dividend growth. Your capital gains portion over and above whatever dividend growth gives you is actually very small. Total return investing is really the mode and the strategy, I think, for all seasons.”
Rather than looking at the highest-available yield (which isn’t necessarily a sound strategy since abnormally high yields often reflect stock prices that are low for a reason), a preferred approach for total-return investors is to seek stable and growing dividends. That means investing in quality companies that Huber describes as businesses that “need to be growing their earnings and more importantly their cash flow,” he says. “You are buying into companies that are growing and returning a bigger portion of cash flow, hopefully [with] consistency, to shareholders over the course of the years.”
There’s a potential added benefit to total-return investing through dividend growth. Dividends can provide a cushion against market volatility, as recent months’ experience has shown. Investors should, however, be careful about their priorities and assumptions when considering more dividend-stock investing and market volatility, Peters notes. “Taking on a dividend strategy, a high- yield strategy, just for the sake of lower volatility misses the point, because the experience we had in the last crash really makes that plain,” he says. “Any stock, at any time, can drop 5, 10, 20 percent. The whole market can drop 20 percent. The whole market in that case dropped 60 percent. You can’t control those variables as an investor. You can’t control the direction of the market in any one given day or week or year.”
Peters believes the solution is to recognize the market’s volatility and move beyond capital gains as the portfolio’s sole source of profits. “What you need to do is find a differentiated approach, which will allow you to participate in the returns of the underlying businesses without necessarily needing to get it through capital gains,” he says, “and that’s what [makes] the dividend part of the strategy … so valuable.”
Ways to Boost Total Returns
The decision to provide shareholders with strong total returns requires an alignment between corporate goals and operations, experts say. Johannesburg, South Africa-based Sasol Limited (SSL), an international integrated energy and chemicals company, says it focuses on the controllable factors of its business to enhance total returns. Consequently, operational stability, cost containment and margin improvement in the company’s foundation businesses take priority in an effort to deliver solid and sustainable earnings generation in the short term, explains Chief Financial Officer Christine Ramon.
From a longer-term perspective, capital prioritization and portfolio management of capital projects ensures that Sasol balances long-term growth with competitive returns, Ramon notes. “Furthermore, through our progressive dividend policy we are committed to growing dividends annually, while matching dividend growth with earnings growth over time,” she says.
Sasol can achieve this goal as a result of its strong cash-generating ability and robust balance sheet. That cash flow allows Sasol to fund its growth plans and pay attractive dividends. “We have a robust portfolio of businesses that are geographically diversified, which enables Sasol to produce strong returns consistently,” explains Ramon. “We have consistently exceeded our targeted earnings growth rate of 10 percent in U.S. dollar terms on a three-year-moving- average basis.
“Our annual equivalent growth rate in total shareholder returns over the past five years, calculated as of December 1, 2011, is 12.2 percent in U.S. dollars and 9.3 percent in ZAR (South African Rand),” she continues. “In the past year, our dividend yield has exceeded 4 percent, which positions Sasol competitively compared to our peer group. In addition, over the past six years, we have executed two share-repurchase programs that have enhanced total shareholder returns over that period.”
Some business models, such as master limited partnerships (or MLPs), are intrinsically geared for total return. At Plains All American Pipeline L.P. (PAA) in Houston, for example, returns come in the form of quarterly distributions to equity holders plus potential share appreciation.
“We aim to deliver a competitive risk-adjusted total return,” says Roy Lamoreaux, director of investor relations with Plains All American Pipeline, which transports, stores, terminals and markets crude oil, refined products and liquefied petroleum, as well as other natural gas-related petroleum products. “Our 10-year average annual total return has been 17 percent, which compares very favorably to the broader markets and many other investment alternatives.”
Plains All American Pipeline sees the delivery of total return as a key factor in the company’s longer-term success. “Since we pay the majority of our available cash each quarter to our investors in distributions, we receive our growth capital through the capital markets,” Lamoreaux says. “The returns we deliver stakeholders clearly impacts our ability to access capital and thus to grow.”
Growth allows Plains All American Pipeline to diversify its operations. In turn, Lamoreaux says, the company’s assets and business model have generated durable, predictable returns in a variety of energy markets and economic conditions. “We grow through disciplined investment in our existing or new assets, either through organic growth (construction) or acquisitions.”
That strategy has paid off for investors, he notes. Over the past 10 years, PAA investors’ annual total returns of 17.2 percent have exceeded the Dow or the S&P 500 by 14.6 percent and 12.3 percent, respectively.
Implementing a total-return strategy requires a balance between using free cash internally and paying it to shareholders. At Enterprise Products Partners L.P. (EPD) in Houston, this strategic process involves examining the balance sheet, capital expenditure budgets and projected cash flow, says Randy Burkhalter, vice-president of investor relations for Enterprise Products Partners, which provides midstream energy services to producers and consumers of natural gas, NGLs, crude oil, refined products and petrochemicals.
“We have announced growth projects in place with visibility to future cash flows,” says Burkhalter. “Each quarter, we look at the cash we expect our businesses to generate before we decide to declare the quarterly cash distribution, and that cash covers the distributions we pay to our limited partners. The coverage has historically been 1.2 times the distribution, with higher coverage lately.”
The firm’s integration supports it total-return emphasis, because the company is a builder of systems, not a collector of assets, says Burkhalter. “We don’t just go out and buy something up in, say, the northwestern United States that doesn’t integrate with our pipelines or infrastructure,” he says. “We wouldn’t go buy something in New York or Maine just because it’s a great asset. It has to integrate with our energy value chain; it has to produce cash flow downstream.”
As an example, Burkhalter cites the company’s decision to build gas-processing plants in the Wyoming- Colorado area. “We built the plants, because they connect to the company’s natural-gas-liquids pipeline that brings mixed NGLs to Hobbs, New Mexico, to be fractionated,” he explained. That integration allows Enterprise Products Partners to “charge a fee to fractionate and a fee to pipe the NGLs to market or storage,” Burkhalter explains. “That gives us an energy value chain of fees, and we utilize our integrated system.”
Investors have benefitted from that approach. According to Burkhalter, the company has raised its quarterly distribution for the last consecutive 29 quarters and 172 percent since the company’s IPO in 1998.
National Retail Properties Inc. (NNN), in Orlando, Fla., a real estate investment trust that invests in single-tenant net-leased retail properties nationwide, also focuses intensely on producing strong total returns for investors. According to Kevin B. Habicht, executive vice-president and CFO, NNN’s annual total return of 11 to 13 percent over the past one-, three-, five-, 10- and 15-year periods represents strong absolute performance and compares very favorably with the 5 percent or less total return of the S&P 500 over those same respective periods.
A key part of NNN’s total return is the cash dividend the company pays every quarter. “For 22 consecutive years, the cash dividends paid in any given year has increased from the prior year — a track record relatively few public companies can match,” says Habicht. “Many investors are attracted to NNN’s current 5.8 percent dividend yield and that track record of dividend increases. We intend to perpetuate NNN’s business strategy of owning and acquiring well-located retail properties net leased to creditworthy tenants, which has produced the stable and growing operating results that have led to our strong historical total returns.”
Other firms strive to produce solid total returns as well through their distinct corporate and financial strategies, such as LTC Properties Inc. (LTC), a self-administered real estate investment trust that invests primarily in the long-term care sector of the health-care industry. “Our primary objectives are to sustain and enhance stockholder equity value and provide current income for distribution to stockholders through real estate investments in senior housing and long-term care properties managed by experienced operators,” said CEO and President Wendy Simpson. “To meet these objectives, we attempt to invest in properties that provide opportunity for additional value and current returns to our stockholders and diversify our investment portfolio by geographic location, operator and property type.”
Blending corporate goals with shareholder interests is no easy feat, experts say. But businesses that have strong track records of producing and enhancing total returns over time have mastered the ability to prioritize growth plans and manage their own investment portfolios while expanding dividends and earnings for investors.
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