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December 26, 2011 at 07:00 PM
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.”
