From the January 2013 issue of Research Magazine • Subscribe!

Total-Return Investing: The Case Stays Strong

A total-return approach provides exposure to assets that behave differently in different market environments

While clients’ financial goals and risk tolerance tend to drive their portfolio allocation, there is a significant role for total-return investing among most investors, including those focused primarily on income or growth, experts say.

“Ultimately, while growth and income are treated differently from a tax perspective, both of them are important components of investment performance,” says Laura Thurow, CFA, director of private wealth management research with RW Baird in Milwaukee. 

“To focus only on one or the other ignores part of the story. We think about total return, because ultimately whether it comes through growth—and growth can come on the bond side, as well—or whether it comes through income—which can come on the equity side, as well—they both play an important role in getting to the ultimate objective of portfolio performance,” Thurow explains.

Diversifying away from the risk-return profile of a single asset is another reason why investors should consider total-return investing, the analyst notes. 

A total-return approach provides exposure to assets that behave differently in different market environments. With stocks, she notes, growth tends to be the primary driver in a strong market environment; dividends are a larger driver of total return in challenging markets. 

“Having both of those components, where one works better than the other in each of those environments, has been a nice thing to have,” adds Thurow. In addition, dividend-focused stocks are generally a more defensive type of investment, because the companies are choosing to return capital to shareholders as opposed to retaining the cash for growth.

For Questar (STR), a Salt Lake City-based natural gas company, significant consideration is given to its earnings-retention ratio when setting its corporate dividend policy, according to Kevin W. Hadlock, executive vice-president and chief financial officer.

“We want to ensure the company retains sufficient earnings and cash flow to fund the investment opportunities that drive earnings growth,” says Hadlock. “Our current dividend-payout ratio target is about 60%, which is competitive among our peer group.”

Cash Focus

In general, many total-return opportunities start at the corporate level with management decisions on how to use free cash flow: Should they reinvest that cash internally, buy back shares or pay out some portion of these funds to investors? (These choices influence the market’s perceptions of the company’s shares, or units, on multiple levels and influence the securities’ behavior in the markets.) 

Cash-flow deployment at CVS Caremark (CVS), for instance, is guided by a disciplined, risk-adjusted decision-making process designed to achieve the highest possible returns for shareholders, according to Mike McGuire, senior director of investor relations for the pharmacy chain, which also manages drug benefits and runs a network of clinics nationwide. 

The company has targeted a dividend payout ratio of about 25% to 30% by 2015, McGuire says, and is on track to achieve that goal. “We’ve raised our quarterly dividend by 86% over the past two years, and our payout ratio currently stands at 21%,” he notes. 

“We seek to use additional, excess cash to complete high-return-on-invested-capital, bolt-on acquisitions that strengthen our position in fast-growing segments of the market,” McGuire adds. “Absent more attractive value-enhancing projects, we will use excess cash to complete value-creating share repurchases, with approximately $3 billion to $4 billion expected to be available annually, on average. In 2012, we returned approximately $5 billion to our shareholders through dividends and share repurchases.”

An important consideration for total-return investors, says J. Michael Gibbs, senior vice-president and co-head of the equity advisory group with Raymond James in Memphis, Tenn., is the ability of the company to grow the distribution or dividend over time. 

While dividends are not guaranteed, Gibbs explains, the ability to grow them typically means the company has an expanding business or is using the business to return value to the shareholder. The mistake some investors make is to buy the absolute highest yield, an approach that has not produced the best results over time.

To grow dividends requires discipline, experts say, for both investors and firms. The management of a company’s, or a partnership’s, financial structure to facilitate distributions also plays a crucial role in generating returns. 

For ONEOK of Tulsa, this process requires the maintenance of a total debt-to-capitalization ratio of about 50% debt and 50% equity, according to Andrew Ziola, director of investor relations and communications for the firm, which gathers, processes, stores and move natural gas. This structure, Ziola adds, provides the firm with increasing free cash flow driven by growth. Furthermore, the cash flow benefits ONEOK unitholders. 

“We expect to increase ONEOK’s dividend 65% to 70% between 2012 and 2015 and have affirmed a long-term dividend payout target of 60% to 70% of recurring earnings,” he says. “Since January 2006, the company has increased the dividend 14 times, representing a 136% increase during that period.” 

Historical Patterns, Low Rates

Dividends have been a large component of the historical returns generated by the stock market, says Gibbs. In fact, the S&P 500 produced an annualized price return of 5.89% from December 31, 1936, to December 31, 2011, according to Bloomberg data, he notes. When taking into account dividends reinvested in the index over this time period, the analyst adds, this increased the annualized return by 40% to 9.88%. 

A study conducted by FactSet Research supports this claim. In a 20-year back-test study, Gibbs explains, dividend-paying stocks in the S&P 500 were separated into three categories based on trailing-12-month payout ratios. 

The first category was stocks that increased the trailing-12-month payout ratio; the second category held the trailing-12-month payout ratio steady; and the third group decreased the trailing-12-month payout ratio. Stocks in the first category outperformed the S&P 500 and other categories by a wide margin.

To produce such strong returns over time, companies have to carefully manage their financing. LTC Properties (LTC) in Westlake Village, Calif., for example, says that its financing strategy has been essential to its dividend policy.

According to Pam Kessler, executive vice-president and chief financial officer of the health-care REIT, low long-term bond rates have been very beneficial to the firm’s growth and shareholders. “During 2012, we sold approximately $86 million in senior unsecured notes that bear interest at 5% and mature in 12 years,” Kessler says.

“We used the proceeds to acquire long-term care properties at a generally accepted accounting principles, or GAAP, yield of approximately 10%. In turn, we increased the dividend in the third quarter from $0.145 per month to $0.155 per month. We target a funds available for distribution, or FAD, payout ratio of approximately 80%,” she explained.

The result? Since 2003, LTC has grown its annual dividend from $0.65 to $1.79, which has produced a compound average growth rate, or CAGR, of 12.6%.”Our current annualized dividend is $1.86 or $0.155 per month,” shares Kessler.

Other companies cite a low cost of debt as a favorable factor in their dividend-related strategies, like Magellan Midstream Partners (MMP) in Tulsa. The firm, which transports, stores and distributes petroleum products, also notes that it takes precautions against higher rates that could reduce available cash flow. 

“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,” says Paula Farrell, director of investor relations, planning and reporting for Magellan. 

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

Producing consistence dividends also involves keeping a careful eye on a company’s key businesses, along with growth and sustainability, experts say. “When selecting securities which we feel will produce growing distributions, we use a combination of financial ratios such as payout ratios, free cash flow, balance sheet and earnings trends, along with an understanding of the business mix,” explains Gibbs.

For National Retail Properties (NNN) in Orlando, this means working to maximize the value of its existing property portfolio, keeping tight control of costs—especially debt costs—and acquiring properties that increase cash flow and allow for higher dividend payments, says CEO and Chairman Craig Macnab.

Changing Wisdom 

Josh Peters, CFA, editor of Morningstar’s Dividend Investor newsletter in Chicago has methodically reviewed U.S. equity market returns of the past 100 years. He notes that the conventional wisdom of 9 to 10% long-run returns on equities “is in fact correct.”

Over that period dividends have contributed roughly 4% of the total 9% to 10% returns. However, what’s different today is that the dividend yield is only about 2.2 to 2.3%, even though dividends are growing. “That’s steers you, I think, back in the direction of wanting to get those higher dividend yields now along with at least some growth that exceeds inflation.” 

James Cunnane, managing director and portfolio manager at St. Louis-based FAMCO MLP, a division of Advisory Research, focuses on distribution, particularly within the energy-infrastructure field. In his view, a lower distribution with growth potential is typically a better investment than a higher distribution that is expected to be flat or worse declining.

Lower yielding investments with growth will trade more like equities, while higher yielding, low growth securities will trade more like fixed-income securities, says Cunnane. “We believe that equity-like investments will generate higher total returns in the slow growth, rising interest rate environment we are forecasting.”

As Gibbs looks at areas that offer the potential to increase future dividends, he is bullish on technology thanks to its abundance of cash and strong fundamentals. In the last few years, he says, investor attention on dividends has caused many companies in the IT sector to initiate dividends or increase dividend payout ratios. 

“The sector has generated a lot of excess cash flow during this time frame, so it has the cash to continue to raise the dividends,” says Gibbs. “Finally, many of the companies in the sector have a strong balance sheet, with many companies carrying large net cash positions. 

“This is important because technology is a cyclical sector. The cash balances will provide flexibility to maintain dividends should the economy turn down and earnings fall short of the dividend payment.”

In addition, experts point out, investors aren’t restricted to U.S.-based investment opportunities, of course. By expanding their horizons, investors can seek additional total-return opportunities that also add diversification to their portfolios. 

Ryan Brown, CFA, investment product specialist with MFS Investment Management in Boston, notes that “approximately 50% of the investable stock market universe is comprised of companies based outside the United States.” 

Furthermore, as more U.S.-based firms do business overseas for growth-related reasons, the potential universe of total-return leaders is likely to expand both at home and abroad.

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