MARKET COMMENTARY

Dividend Builders: How Steadily Rising Payouts Can Boost Returns

08.30.2016 - Frank Felicelli, CFA

Our top investment themes represent the best ideas of our portfolio managers—not about specific securities or asset classes, but about the practices they have identified as sources of strength in today's market environment.

In this spotlight article, senior portfolio manager Frank Felicelli explores the prominent role of dividends in the stock market's performance over the past 80 years and explains why we think dividend growers are such a compelling investment.

Dividend-paying stocks are attracting a lot of attention these days, especially from income-oriented investors who are frustrated with near-zero yields in the bond market.

While we understand that strong dividend payouts can be an attractive alternative for income investors in these surroundings, we take a broader, more comprehensive view of the market. Not only do we look for strong dividend payers with attractive potential for current income, but we are especially interested in strong dividend growers; issuers that have demonstrated the willingness and ability to boost their dividend payouts consistently over multi-year periods.

Dividend Growers Are a Top Investment Theme
Why are we so committed to dividend growers? One reason is that dividends have been responsible for a sizable portion of stock market returns - an average of 50% over the past 80 years (CHART 1). Those contributions fluctuate from one decade to the next, depending on the level of price appreciation in the market, investor appetite for dividend-paying stocks versus capital appreciation, the tax treatment of dividend income and capital gains, and a host of other variables.

CHART 1: Dividends Make a Significant Contribution to Returns
Percentage of S&P 500 Total Return

*Not meaningful because returns were negative. Source: Strategas Research Partners. 

The long-term significance of dividend growers is often underappreciated by investors. In our view, the case is compelling:

  • Valuations for dividend growers appear historically low (CHART 2).
  • Companies that consistently raise their dividends tend to generate relatively strong revenues, earnings and cash flow, so they tend to be fairly resilient. In the first two months of 2016, which was an especially rocky period for global equities, dividend growers gained 2% while the S&P lost -5.5%. 
  • Many dividend growers compete internationally. Positive returns from overseas may help offset weaker returns in the US (and vice-versa).
  • Dividend growers have helped to provide investors with an effective hedge against inflation, increasing their payouts at an average rate of 5% to 6% each year.
CHART 2: Dividend Growers Appear Attractively Priced
Forward P/E Ratios for the Highest Dividend Growers (1976 to July 2016)
 
Source: Empirical Research Partners Analysis; equally-weighted data smoothed on a trailing six-month basis.
Dividends Demonstrate Discipline
The economic headwinds that confront US corporations today have not curbed our enthusiasm for dividend growers. While dividend payouts are not climbing as sharply as they have in the past, we do not believe this moderation foreshadows a sharp decline.
 
On an absolute basis, dividend payments continue to rise, totaling $114 billion in the first quarter of 2016, according to FactSet. That marks the highest quarterly dividend payout for the S&P in 10 years. FactSet expects total dividend payouts for the S&P 500 to improve by 5% this year.


Of course, dividends are never guaranteed. But we are confident that issuers who have established a strong track record of paying dividends also have a strong incentive to continue moving along that same path. Their management understands that consistently paying dividends and raising those dividends demonstrates fiscal discipline.

While some critics argue that a steady and growing dividend payout means a company is having trouble finding more constructive uses for its cash, we respectfully disagree. New companies use cash to gain traction in the marketplace, expand their research and development efforts and build reliable distribution networks. But as they mature they allocate more cash to projects that they think show the highest ROI potential. They pass the rest of their profits along to shareholders.

Our experience shows that most dividend growers cut their payouts only under the most extreme levels of market duress. A long history of steadily growing dividend payments is often seen as a sign of long-term earnings power, a prudent business model and a commitment to return cash to shareholders.

High Demand for Dividend Yield
The search for income took a dramatic twist this June when the Fed eased back on its plan to start raising interest rates. Suddenly, many income-oriented investors acknowledged that the economy was indeed sluggish, that fixed income yields would probably be anchored near zero for a very long time, and that they should probably start looking elsewhere for investment income.

As a result, investors started gravitating toward the stock market, searching for sectors that appeared to provide a measure of stability and a reliable stream of income. Two of the most popular equity market sectors were utilities and telecom, which are generally considered defensive sectors with dividend payouts that are higher than the market's average. 

Investors were willing to pay a premium for these high-dividend-yielding sectors in June and July, pushing P/E ratios for utility and telecom stocks to levels we would consider extremely high relative to their historical averages and other sectors of the S&P 500. At the end of July, the average utility stock was trading at a P/E multiple of roughly 18.8x, which we consider expensive given the modest revenue and earnings growth expectations for the sector in 2017.

Of course, we are also looking for companies that offer growth potential, but only at a reasonable price.
 


This communication is intended solely to provide general information. The information and opinions stated are as of August 30, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


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