It’s been a good ride recently for total-return investors. First, the S&P 500 rose 25.2% through early December; global stocks, as tracked by Morgan Stanley, improved 21.6% during the same period.
Second, the percentage of S&P 500 stocks paying dividends as of the third quarter of 2013 was 83%, the highest recorded level in the past 15 years, according to a recent issue of “Dividend Quarterly,” published by FactSet Research Systems.
In addition to a greater number of large-cap companies paying dividends, more mid- and small-cap companies are paying them. The proportion of dividend payers in the S&P 400 mid-cap index has increased from 58.3% to 65.8% since the first quarter of 2009. Additionally, the percentage of dividend-paying stocks in the S&P 600 small-cap index is up to 49%, a level that FactSet describes as “unprecedented since at least the mid-1990s.”
Still, experts point out, some companies today prefer to buy back shares rather than pay dividends. The reason? Buybacks are “very easy to turn on and off,” says Josh Peters, CFA, equities strategist and editor of the Morningstar “DividendInvestor” newsletter.
“In contrast, once a company initiates a dividend, the market expects that dividend to be paid at that rate going forward ‚Äì if not increased over time,” Peters explains. “This imposes much more discipline on the management of a company, which can’t take money being spent on dividends and divert it to other uses without potentially causing an adverse reaction from the market.”
Public companies with consistent dividends and appreciating stock prices—the secret sauce of total returns— have such disciplined management, experts note, adding that such firms are rare. Furthermore, those firms that are able to take such a consistent and strategic approach to their businesses are able to produce strong results for shareholders, management and employees alike.
Few companies have management teams “that are capable of investing in a really broad array of opportunities and doing well for their shareholders, who increasingly are looking to get cash back,” Peters says. This is the real job of corporate executives: run the business that they have as effectively as possible, exploit growth opportunities in their existing business footprint and do things that they are good at in markets in which they have a competitive advantage, he points out. Such behavior can lead to powerful total returns over time.
Dividends don’t lie. While a company may be able to use accounting conventions that make its financial results look better, at least in the short term, dividends and dividend increases require free cash flow and managerial commitment to distribute that cash over the long term. These qualities are indicators of well-managed businesses, as the NASDAQ Dividend Achievers website points out:
Companies that pay regular dividends tend to be in better financial health and produce sustained earnings and revenue growth.
Dividends help identify well-managed companies; every dividend declaration represents a promise by management and a vote of confidence by the board of directors in the company’s leadership.
Companies that consistently raise their dividend payouts also raise the bar on their own performance expectations.
Shares of dividend-paying companies possess built-in value that makes them generally more resilient in down markets, with solid appreciation potential during earnings-driven market upturns and with less price volatility.
Corporate managers can use free cash flow in several ways, including dividend payments, share buybacks, or internal reinvestment. CMS Energy (CMS) in Jackson, Mich., works to create a balance that provides its investors with earnings per share (EPS) and operating cash flow growth at the high end of its peers, according to Tom Webb, the company’s chief financial officer. Webb says CMS is able to grow its EPS and dividend at a 5% to 7% pace each year, which is slightly better than most of its utility peers.
“In our sector, this is driven by capital investment, typically 50% of which is equity-based,” says Webb. “We are allowed to earn 10.3% on that equity, which is a more attractive return then alternative uses of cash.
“We are fortunate to have a large and growing capital investment program of needed (not just wanted) projects, which we limit in size only to make sure that our customers’ base rates do not grow faster than inflation, helping to ensure that the real impact is a reduction for our customers,” Webb explains. “This permits our company to have a sustained level of investment and growth in earnings, operating cash flow, and dividends at the high end of our peers, making CMS Energy a company with a premium return and minimal risk in our sector.”
Companies produce strong dividends and total returns, says Peters, by: (1) investing sufficiently in their existing businesses in order to maintain market position; (2) exploiting expansion opportunities in their existing lines of business; and (3) setting dividends at the highest levels they can sustain, even during a downturn.
This playbook seems to be the right recipe for Austin, Minn.-based Hormel Foods, for instance. “We focus on generating growth over the long-term through new product innovation, expansion in international markets, reinvestment in our existing businesses, and strategic acquisitions,” explains CFO Jody Feragen. “Our long-term focus provides a platform of steady growth which has allowed us to increase our dividend for 48 consecutive years.”
As part of the total-return playbook, companies have to tailor policies to support the right financial strategies, while properly balancing this goal with the competing uses of cash flow. Tony Ivins, corporate treasurer with Questar (STR) in Salt Lake City notes that the company’s priority use of cash flow is to first organically invest in each of its integrated businesses to drive growth. After meeting investment needs, the company then focuses on dividends and possible share buybacks.
“We want to maintain a competitive dividend, targeting a payout ratio of 60%,” he says. “Only after funding organic growth and paying a competitive dividend will we consider a share repurchase program. In 2012, we repurchased $92 million in common stock and have ongoing authorization to repurchase up to 1 million common shares per year to offset share dilution.”
For some companies, such as real estate investment trusts (REIT), their organizational structure determines how much income they distribute. Kevin Habicht, chief financial officer at National Retail Properties Inc. (NNN) in Orlando, Fla., notes that as a REIT, the company is required to distribute at least 90% of its taxable income to shareholders annually.
That requirement limits the amount of free cash flow to reinvest or buy back shares. “Because we have sizable investment opportunities at good risk-adjusted returns, we typically reinvest any available free cash flow after paying our dividend, as well as raise new capital for those acquisitions,” says Habicht.
There is an academic position that under certain idealized assumptions about costs and taxes, a company’s capital structure and dividend policy is irrelevant. Investment results, however, don’t support the theory.
Consider these historical total return statistics for the S&P 500 between 1972 and 2010:
Among dividend payers, FactSet reports that since the dot-com bubble burst in the early 2000s, the level of dividend payments has influenced returns. The lowest yielding dividend stocks—defined as the bottom quartile—have had low returns while the highest yielding stocks have outperformed the S&P 500. The difference in returns can be significant.
“Since February 2009, the highest yielding quartile (with an average yield of 5.6%) registered an equal-weighted, monthly average return of 2.6%, while the lowest yielding quartile (with an average yield of 0.7%) averaged a monthly return 1.7%,” the research group says.
Of course, relative returns vary over time with market conditions. Since June 2102, FactSet notes, non-dividend payers’ monthly, equal-weighted performance has been 2.4% versus 1.9% for dividend stocks.
A long-term perspective highlights the value of dividends for total return investors. The average total return from 1926 through 2012 for the S&P 500 index has been 9.7%. Capital appreciation accounted for 5.6% of that value while dividends contributed 4.1%, or roughly 42 percent of the total return.
Guinness Atkinson Funds studied the S&P 500 index’s returns from Dec. 31, 1940, through Dec. 31, 2011. The group found that the importance of dividends increases with investors’ time horizons.