In Jeremy Siegel’s authoritative classic Stocks for the Long Run the Wharton Business School professor analysed over 200 years of US stock market data. He concluded that the most effective equity investing strategy is to focus on quality dividend growth stocks. He argued that the contribution of dividends to an equity portfolio’s performance outweighs returns achieved from other mainstream investing approaches such as value, growth, capitalisation or index investing.
Dividend growth companies often have strong businesses that enable them to generate excess cash, over and above what’s needed to sustain their companies. Paying a consistent and growing dividend telegraphs to investors a sense of management’s confidence in the future.
When corporations earn profits they can use those earnings to expand product lines, make strategic acquisitions, buy back stock or pay dividends. There are often raging debates as to whether companies should even pay dividends. Some believe that if businesses can grow earnings at a high pace, and generate a good return on equity, they’re better off re-investing profits into expanding the company. After all, they argue, Apple Inc., one of history’s best performing stocks, just paid a dividend last year – its first in 18 years.
But others suggest it’s better to receive consistent dividend than watch some companies squander shareholder wealth on ill-advised acquisitions. History is littered with examples of bad acquisitions followed by huge subsequent asset write-downs, most infamous of which is Time Warner’s $54 billion loss buying AOL.
Dividend growth stocks tend to be mature large-capitalisation, multi-national companies with strong brands and leading market share. Very often they fall into the consumer non-cyclical bucket, in industries such as pharmaceuticals, personal care, foods, beverages and tobacco. Historically, these stocks have outperformed the overall market, especially in bear cycles, as their products are often in high demand – even at the worst of times. Companies like PepsiCo, Colgate-Palmolive and McDonalds are examples of large capitalisation stocks which make up the S&P500 Dividend Aristocrats – an elite group which have managed to increase their dividends annually for 25 years.
It’s crucial not to fall into the trap of investing in stocks solely for their high dividend yields. If a company has an exceptionally high yield (dividend per share divided by the stock price) – this could signify trouble ahead. Sometimes companies with high dividend yields experience a slide in share price, usually due to the markets discounting an imminent dividend cut. In the US, dividend-paying companies almost always pay regular quarterly dividends with a consistent growth traject-ory. These companies take great pains to grow their dividends annually, as this is often perceived as a sign of a growing company with a healthy balance sheet.
US companies rarely increase dividends if there is doubt regarding their sustainability, especially since cutting a dividend is often regarded as a concession that there is trouble at the company.
On February 13, 2013 CenturyLink, a US telecom, plunged 23 per cent after it announced an unexpected 26 per cent cut in its dividend. Conversely, outside the US it is quite common for companies to not grow or pay consistent dividends and there may be little negative consequence to a company’s share price, should dividends be cut. There are a number of import-ant metrics to consider before buying dividend growth stocks. Does the company have an uninterrupted history of growing dividends at close to double-digit annual rates? Is enough cash available to shareholders, after annual capital expenditures have been made (aka free cash flow which subtracts capex from operating cash flow)?
(Some) suggest it’s better to receive consistent dividend than watch (it) squandered on ill-advised acquisitions
The payout ratio which measures the percent of earnings paid in dividends should generally be below 70 per cent. Anything higher may suggest a company will not have enough cash cushion if its earnings or financial condition were to deteriorate.
Microsoft, for example, with a payout ratio of 34 per cent, pays out 34 cents in dividends per share for every dollar a share in net earnings. This gives the company plenty of leeway to pay dividends should earnings fall temporarily.
Don’t be put off by low yields, either. A company yielding 3 per cent today may seem uninspiring, but should the dividend grow at 10 per cent annually, after 15 years the stock will be yielding over 12 per cent!
The attractiveness of many dividend growth stocks is their ability to not only pay attractive dividends but experience handsome price appreciation. A portfolio of good-quality dividend growth stocks has not only historically beaten the returns of non-dividend-paying stocks, but done so with less volatility. Remember, beside dividend growth investing, patience, re-investing dividends and having a long-term investment horizon are all essential to expanding your wealth.
This is the third in a 10-part investor education series which is appearing every fortnight.
Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He is also a lecturer at the University of Malta and the Institute of Investment Analysis.