Total Return Leaders: Sustaining Total Returns

Analysts have had a variety of expectations for dividend stocks in 2014. When equity markets were most volatile, some investors viewed these stocks as more defensive holdings. As interest rates dropped, they continued to be attractive income sources for yield-seeking investors. But as stock prices rose, some analysts wondered if they could be overvalued.

Despite the background noise, dividend-stock investors have benefitted from their holdings, as the overall level of dividend payments continued to increase throughout the year: Dividends per share grew 11.5% for the S&P 500 stocks over the trailing 12-month period ending in July, according to FactSet Research System’s “Dividend Quarterly” report of Sept. 15, 2014.

This was the 14th-consecutive quarter of double-digit dividend growth, the report points out. Furthermore, 85% of S&P 500 companies paid dividends, which totaled over $356 billion for the trailing-12 months, and the dividend payout ratio of 32.3% was “one of the highest non-recession levels in 10 years.” In addition, “the number of companies that increased dividends per share over the trailing-12 months [which was 339] reached the highest level since at least 2000.”

Quality Indicator

Dividends convey valuable information about how executives view a company’s financial condition and outlook. Regular dividends demonstrate solid financial health and sound management. Because dividends require cash, companies that are struggling to maintain cash flow can’t risk committing to regular payouts. Companies that consistently raise dividends are expressing confidence in their business outlook. A policy of sustainable and growing dividends shows that management is keeping its focus on creating wealth for shareholders.

Dividends also impose capital discipline on management, says Job Curtis, head of value and income at Henderson Global Investors in London. While some capital expenditures certainly benefit long-term growth potential, companies can get carried away with capital expenditures and potential acquisitions when business is good, he believes.

“I think having a progressive dividend is a good way [for] companies [to] weigh the pros and cons of how they might spend the money,” Curtis stated. “It leads to better corporate management overall.”

Every company must balance competing demands on its free cash flow, which can be used internally, paid out as dividends or used to buy back shares. For instance, Questar Corporation in Salt Lake City, Utah, sets three priorities for its free cash flow, according to Tony Ivins, vice president of investor relations and corporate treasurer.

The first priority for Questar is investing internally in sustainable earnings and cash-flow generating growth projects. The second priority is to grow the company’s dividend at roughly the same pace as earnings growth. The final priority is returning capital to shareholders in the form of share repurchases.

“Regarding any potential large-scale share repurchase programs, we would prefer to invest internally to grow both earnings and earnings per share, not just EPS via a buyback program,” Ivins explained.

At CMS Energy in Jackson, Michigan, the company attempts to balance its focus on both customers and investors, according to Phillip J. McAndrews, director of investor relations.

“That balance is important as we provide safe, clean, reliable energy at an affordable price for our customers, while growing our earnings per share and cash flow for investors,” McAndrews said. “With an extensive 10-year inventory of capital investment projects, we are able to sustain our EPS growth rate at a pace higher than our peer average of 5% to 7% each year.”

The Role of Dividends

It’s easy to overlook dividends during bull markets, but that viewpoint minimizes the historical contribution of dividends to total returns. According to a 2014 report from Santa Barbara Asset Management, dividend income comprised 42% of the S&P 500′s total return from 1926 through 2013.

There’s a wide variation behind that number, of course, experts say. During some decades, such as the 1940s and 1970s, dividends comprised more than half of the index’s total return. In the 1990s and for 2010 through 2013, however, the contribution was 15% and 14%, respectively.

Dividends also play an important role in other nations’ equity-market returns, Curtis points out. In some markets, such as that of the United Kingdom, the contribution of dividends is higher than it is in the United States; in Germany, it is similar to that of the United States, and in Japan, it is lower.

“It depends which market you’re in,” he added. “In the U.S., [yields are] around 2%, but if you go overseas into Europe and Asia Pacific you can get yields of 3% or more. That’s a very good starting point in terms of future returns.”

Staying the Course

Retail investors often suffer from poor market timing — they buy high and sell low. Earning dividends can alter that behavior for several reasons, says Mike Boyle, CFA, executive vice president and head of asset management with Advisors Asset Management in Lisle, Illinois.

Plus, dividend-focused strategies generally have lower volatility than non-dividend paying stocks, Boyle notes. That reduced volatility can help investors stay the course and remain invested when markets weaken. Receiving income also influences behavior, whether investors retain or reinvest the income.

Investors earning current income tend to be more patient. In a sense, they’re getting paid to wait for the next market rally. “I think they are afforded the luxury of being a little more patient, which keeps them invested,” he said.

Income Growth

It remains a challenging environment for income investors. The widely anticipated rise in U.S. interest rates hasn’t materialized yet, and slow global growth means that foreign fixed-income yields aren’t likely to increase soon, either.

Dividends can meet the need for income growth. Although the S&P 500′s yield is currently below 2%, payouts of the component stocks can increase over time.

Over a 45-year period, the average growth rate for the dividends of companies in the S&P 500 has been 6.2%, according to Boyle.

The rate of growth has been higher lately, as companies have recovered from the financial crisis: The year-over-year increase is about 11% through November 2014.

This growth rate is likely to revert back to the historical average eventually, though he’s optimistic about near-term prospects: “I think we’ll probably stay in the high single-digits, right around 10% over the next 12 to 24 months,” Boyle said.

The higher-income trend for totalreturn investors differs dramatically from bond investors’ experience in recent decades. A 2014 analysis by Fayez Sarofim & Company compared income payments generated by the S&P 500 stocks and by the Barclays U.S. Aggregate Bond Index from 1979 through 2013. The difference is striking.

“The S&P 500′s annual dividend income from a $100,000 investment grew from $5,234 to $32,416 vs. an actual decline in annual bond income received [to $2,998] from the Barclays index over the same period,” the group reported. In fairness, the lower interest rates that dominated the period generated capital gains for bond investors, but the S&P 500 Index also rose substantially over the same years.