Total-Return Investing: The Case Stays Strong

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.