Let's start with some basics, and most basic of all is that the fundamental role of the corporation is to create and maximize shareholder wealth. If you have been reading Paul Krugman's column in The New York Times or listening to a certain brand of political commentary, you may think that the corporation's basic role is to save the whales, or eliminate income inequality, or solve a host of other societal ills. Now, don't get me wrong here. I firmly believe that businesses should be good corporate citizens, and that they should be held to account when their actions cause harm to society. What I am saying is that if corporations aren't successful at their basic responsibility to their shareholders (owners), then they will not be around to create jobs, contribute positively to their communities, or do anything else that falls under the heading of "corporate responsibility." The payment of dividends is one way that a company can be "shareholder-friendly." The average annual return from stocks in general over the last 80 years has been just under 10%, and about 40% of that return has come from dividends. Dividends are often referred to as the "bird in the hand" part of total return, because even if a stock's price might rise, fall, or remain stagnant with the up and down movements of the overall market, the dividend return is typically more stable and reliable. This is also known as being "paid to wait" for the capital appreciation part of a stock's total return.
If I wanted income, I'd invest in bonds. Oh, if I only had a dollar for every time I've heard that one. Like many misconceptions, though, there is a solid grain of truth here. My approach to dividends is not to view those payments as income, but rather as just a portion of the total return I'll get from a stock. As I noted in my last post here, the meager annual interest income available from the safest bonds right now stands a good chance of being overwhelmed by both the erosion of purchasing power and the decline in the market value of bonds should interest rates rise. My assessment of the total real return likely from stocks versus bonds leads me to favor stocks. The goal of investing, in my playbook at least, is to seek out the highest potential total return. In my hunt for potential stock investments, I regularly run a series of screens to identify stocks with certain characteristics so that I can conduct additional research. My regular readers will not be surprised that those screening parameters involve earnings growth, earnings estimate revisions, relative strength, and various valuation measures. Very rarely do I screen for dividend-paying stocks, but I definitely pay attention to the dividend characteristics of the stocks identified by my screens. The take-away here is that instead of investing for dividends per se, we should stick to those qualities that are most likely to lead to capital appreciation, but then consider how the dividend payers can either enhance total return or reduce risk.
Another mistake some investors are prone to make is to assume that a higher dividend yield is preferable to a yield that is lower. There are at least two reasons to proceed with caution here. First, the list of highest-yielding stocks is likely to confirm the "boring" perception. It is crucial to evaluate a stock's dividend payout ratio (the percentage of earnings paid out as dividends), because if that ratio is too high (above about 65%, for example) it can mean that the company really isn't investing much in its own growth, probably because it doesn't have growth opportunities. Utility companies have historically been favored by investors seeking dividend income, but that's probably not where you are going to find growth. Also, a high payout ratio can be troubling because the company does not have its dividend well covered by earnings. For companies that have stable earnings, such as those in the consumer staples sector, a higher payout ratio can be more acceptable, but for companies with more cyclical earnings, a downturn in profitability could put the dividend in jeopardy.
The icing on the cake here is the potential growth in dividends. As I've noted before, if you buy a $100,000 bond that pays you $3,000 a year in interest, the bond issuer is never going to increase your interest payment because more money is available. The second reason I actually prefer some stocks that have more modest yields is that their potential for earnings growth can also mean dividend growth. While a company's history of increasing dividends is no guarantee that such increases will continue, most companies are loathe to cut their dividends, and a number of firms can increase dividends each year without increasing the payout ratio because earnings are growing. Here is a list of some companies that have increased dividend payments by 10% per year, on average, over the last 12 years:
Abbott Labs (ABT, $57; 3.60% yield, payout 68%)
CVS/ Caremark (CVS, $45; 1.46% yield, payout 25%)
Eaton (ETN, $52; 2.9% yield, payout 39%)
McDonalds (MCD, $100; 2.79% yield, 53% payout)
Nike (NKE, $108; 1.34% yield, 31% payout)
PepsiCo (PEP, $63; 3.25% yield, payout 51%)
Schlumberger (SLB, $78; 1.39% yield, payout 30%)
TJX (TJX, $37; 1.03% yield, payout 20%)
Worth noting here is that Walgreen (WAG, $33), chief competitor to CVS, has a dividend yield of 2.68%, payout of 31%, and a similar history of dividend growth. WAG stock has not done well since the company and Pharmacy Benefits Manager (PBM) Express Scripts (ESRX, $53) could not come to terms to renew their agreement at the end of 2011. This hurts WAG and helps CVS, which several years ago bought its own PBM, Caremark. Once again, the fundamentals of the company and its prospects always trump dividend yield alone.
The $100 billion question on the minds of many investors is, Will Apple (AAPL, $544) start paying a dividend? My honest answer is that I don't care. I want AAPL to do whatever they see as being in the long-term best interests of the company and their shareholders. If that means investing their cash hoard in an iPhone 500 that will brush my teeth for me, then by all means they should go for it. I don't want a dividend as long as they have better investment opportunities for the money. If the company does initiate a dividend, I would expect the stock price to jump in response. Some investment accounts can own only stocks that pay dividends, so some new buyers would likely be picking up shares of AAPL.
The approach I have outlined here applies to how dividends can work in an otherwise growth-oriented portfolio, mainly by giving the investor a source of return other than capital appreciation, a "bird-in-the-hand" that can grow over time. It is certainly possible to construct an equity portfolio that is explicitly designed to generate income, possibly by investing in stocks of limited partnerships, real estate investment trusts, etc. Investors should be wary of stocks where the dividend yield is abnormally high compared with the stock's history and its industry, as this can signal trouble. That is why it is important to know the fundamentals and check the payout ratio.
Finally, another company I'll mention here is Disney (DIS, $42; 1.44% yield, payout 23%), which recently increased their dividend payment by 50%. The increase sends a signal that management is confident in the company's future, which no doubt has helped lift the stock price. And when it comes to being shareholder-friendly, that move almost qualifies as pure "Southern Hospitality."
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If you have any questions, please use the "Comments" section of the blog to post those, and I will plan on devoting some space to "Questions and Answers."
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of ABT, CVS, ETN, MCD, NKE, SLB, TJX, ESRX, AAPL, and DIS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing here should be construed as investment advice or the recommendation to buy or sell any security.
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