From the August 2012 issue of Research Magazine • Subscribe!

Top of the Dividend Charts

Companies with strong dividend-paying records are also attractive in terms of income, reduced volatility and corporate quality, experts say.

With current market conditions and global economic trends, advisors have a good opportunity to introduce more clients to companies that make the Mergent Dividend Achievers roster. According to Mergent Inc., less than 6% of the more than 4,200 North American-listed, dividend-paying common stocks qualify as Dividend Achievers.

The standards for inclusion are high: A company must have increased dividends for the last 10 or more consecutive years and meet certain capitalization requirements. The companies that make the cut span nine industry sectors and more than 35 industries and have consistently increased dividend payments through volatile markets and political climates.

Investor Benefits

What’s the best approach for investors to take when it comes to dividend investing? Experts say that consistency is helpful. (Some investors’ interest in dividend stocks tends to decrease during bull markets, and when equity markets hit a rough patch, investors refocus on dividends’ contribution to total return). It’s better to take an all-weather approach to dividend investing, since the stocks perform well over a range of market environments.

“In the short-term, dividends provide the investor [with] income that is not dependent on the whims of the share price,” says William H. Rogers, CFA, director, global index development with Mergent Inc., in Fort Mill, S.C. “Companies that pay increasing dividends in the aggregate exhibit much less volatility than the overall market. They participate, to a great extent, when markets are up, but they provide better downside risk during bear markets.”

Historically low interest rates also increase dividends’ attractiveness versus bonds for investors seeking current income. The S&P 500’s dividend yield of 2.3% is now higher than the 10-year Treasury bond, an extremely rare event historically, points out Josh Peters, CFA, in the July 2012 issue of the “Morningstar Dividend Investor.” This 2.3%, Peters explains, is weighed down by the 97 S&P constituents that don’t currently pay dividends; if this group is excluded, the other 403 dividend payers yield an aggregate 2.6%.

Retail investors appear to value growing dividends, notes Kevin C. Jones, director of investor relations for Hormel Foods Corporation in Austin, Minn. “While lower interest rates have no impact on our dividend-growth policy, it certainly makes a strong dividend-growth rate more important to investors who are looking for growth and income,” Jones explains.

The income potential is certainly valuable, other experts say. “For investors in the accumulation phase, the reinvestment of dividends allows the investor to purchase more dividend-producing shares to pay increasingly higher income payments in the future,” Rogers notes. “Many companies in the Dividend Achievers increase their cash dividends by amounts greater than the rate of inflation. This protects the purchasing power of the investor in the distribution phase and leads to a compounding of future cash payments for younger investors.”

Historical stock returns illustrate the value of dividends for long-term investors. Jeremy Schwartz, director of research for ETF-provider WisdomTree in New York, notes that over the last 75 to 80 years, the average return on the market is close to 10% a year, with about 4% coming from dividends. “Although that’s changed in many decades, [for] four of the last eight decades in the U.S., you got more returns from dividends than you did from prices,” says Schwartz. “With the latest [decade] in the 2000s, you had basically flat to negative prices; really, your only returns came from dividends.”

Recent research from Al Frank Asset Management supports that contention. The company’s June 2012 report, “The Season for Dividends,” discusses how dividend payers have performed between 1930 and 2011.

Dividend-paying stocks “have delivered better long-term returns than non-dividend payers, with the higher yielders as a group performing best,” the group explains. “Interestingly, we’ve also found that the returns of the middle 40% and highest 30% of the dividend-paying universe seem to have a profound performance advantage over stocks with no or low dividends during periods when the U.S. suffers sub-par economic growth. With most prognosticators not expecting GDP growth to move above 3% anytime soon, the case for mid- and high-yielders grows stronger.”

Producing long-term returns takes a broad outlook and incredibly steady execution of that growth plan through a multi-year period. W. P. Carey & Co. LLC’s objective, for instance, is to generate steadily increasing income to support consistent dividend growth for its investors over the long term, according to Cheryl Sanclemente, the company’s corporate communications manager in New York. To that end, the company’s dividend has increased each year since going public in 1998 and for the past 45 consecutive quarters.

“The business model is based on a core strategy of investing in a diversified portfolio of critical operating properties leased to credit worthy companies on a long-term basis,” says Sanclemente. “Most leases are structured to provide for rent escalation over time, and the assets acquired are typically financed on a moderately leveraged basis with non-recourse debt.”

Corporate-Quality Indicator

Paying dividends, in general, is not an automatic business result: A company needs to have the confidence that its free cash flow is sustainable for the foreseeable future before declaring or increasing a dividend. That ability to pay increasing dividends, of course, is a positive sign for investors.

“It’s very good for a company to raise its dividends every year,” said Morningstar’s Peters in an interview. “That says a lot about the company and its management. Still, it’s not a guarantee of future performance. A good dividend record is a starting point for analysis. You also have to look at the business, the balance sheet and how dividends would fair in the next recession.”

While advisors and investors shouldn’t ever take future performance for granted, experts say, companies with strong dividend-paying records do warrant special attention. “Although Mergent does not make determinations on a company’s corporate governance, companies with rising dividends for a considerable amount of time appear to exhibit good cash-management practices,” explains Rogers. “More important, companies with a significant history of raising dividends appear to be ‘wide-moat stocks’ that have a competitive advantage in the market relative to just dividend-paying stocks.”

Dividends also impose a degree of corporate financial discipline that benefits investors, because the market punishes firms that cut or eliminate their dividends. “Companies are loath to reduce their dividend or not pay a dividend entirely if they’ve already had one in place,” says Rich Powers, a senior investment analyst with the Vanguard Group in Valley Forge, Pa. “And so, having a dividend and a policy around it, I think, provides a level of structure and framework that guides behavior in a positive way for shareholders on one score.”

Financial executives at companies that have been classified as Dividend Achievers agree with Powers’ analysis. Kevin Habicht, executive vice president and chief financial officer at Orlando-based National Retail Properties Inc., points to the real estate investment trust’s conservative balance sheet and careful underwriting of new investments as key dividend-policy supports.

These supports provide the foundation for National Retail Properties’ consistent operating results, which have allowed the company to increase its annual dividend for 22 consecutive years, he says. Also, “thoughtful” pacing of dividend increases has allowed the company to increase the dividend in good times and bad times.

In some cases, such discipline is based on a company’s conservative management philosophy, which—along with successful financial planning and business execution—can allow the firm to raise its distributions with confidence. “This discipline takes shape in how we manage our balance sheet by maintaining an investment-grade credit rating with a significant line of bank credit for future financing flexibility,” says John Chandler, chief financial officer at Magellan Midstream Partners L.P., in Tulsa, Okla.

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

The importance of dividend-paying discipline may be even more critical when it comes to international stocks, WisdomTree’s Schwartz believes. He notes that in the emerging markets, over 94% of the companies pay dividends. Those dividends provide an important signal to investors of the firms’ actual profitability and the presence of cash flows, he notes. “It helps give an extra level of oversight,” as well, Schwartz says.

 Dividends’ Predictive Power

Research conducted over the past decade also has found that higher dividends go hand in hand with higher earnings.  When looking at whether dividend policy, as measured by the payout ratio of the U.S. equity market, forecasts future earnings growth, Robert Arnott of Research Affiliates and Clifford Asness of AQR found a strong relationship: “The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low.”

Another research team—Ping Zhou and Ruland William of the City of New York University—examined a large sample of companies’ payouts over a 50-year period and found that high-dividend-payout companies “tend to experience strong, not weak, future earnings growth.”

This potent earnings record, along with benefits like attractive levels of current income, reduced volatility and a standard of corporate quality, are sound reasons for advisors to encourage clients to refocus on dividends.

 

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