Creating Income Through Dividend Investing. Dividend Stock lists and tools for income investors. Dividend Ladder was created to provide useful dividend data to the income investor community. We have built multiple dividend lists that are updated monthly and we publish 2-3 new articles per week. Our premium dividend service includes a set of tools and rankings for the best dividend stocks.
• Excellent long-term outlook with global food demand virtually guaranteeing a market for the company’s GM seed line
• Best of Breed position with #1 or #2 market share in five core markets
• Strong cash flow generation and plans for shareholder cash return as part of major cost-saving restructuring
I’ve never been a fan of market timing or thinking I could ‘beat’ the market buy jumping in and out of stocks. The long game has always worked best for me, picking quality companies that will put cash in my pocket and grow their share price.
But every once in a while, the market goes into one of its moods and sells off a sector without really thinking about it. Sales for an industry take a tumble or prices get hit for some reason and the market looks at it like it’s the end of the world.
But some sectors are just prone to big cyclical swings. Agricultural commodities are the best example with booms and busts so frequent you could set your watch by them. Corn prices have peaked six times in the last 100 years only to come crashing down as the supply and demand picture changes. Just recently corn prices peaked at $8.54 per bushel in 2012 only to plunge 54% to under $4 this month.
The selloff in grain prices has taken the entire sector down with it but does anyone really believe that ag prices won’t go zooming higher eventually? Research shows that crop yields aren’t sufficient to feed the world’s booming population. Global grain supply needs to double by 2050 to meet food demand and the average yearly increase in crop yields of 1.2% is half of the yield growth to get there. The deficit in corn alone could be as much as 100 million tons per year by 2025.
Monsanto (NYSE: MON) is the best positioned to take advantage of the eventual rebound in crop prices and the long-term demand for grains. The company created the genetically-modified crop market and made the decision early to license its seed traits to competitors. This has led to an almost universal adoption of the company’s GM business with 90% of soybeans and 80% of corn in the U.S. carrying a Monsanto trait. Besides a huge stream of licensing revenue, it also helps to drive sales of the company’s Roundup line of weed killer which can be used on crops that contain a special trait to protect them from the chemicals.
The $41 billion biotech agricultural giant holds a #1 or #2 market share in its five largest markets. The shares have come down 30% off the 52-week high but have still managed to produce a 12.6% annualized return over the last decade.
Besides the general selloff in crop prices, Monsanto has seen its sales hit by the stronger dollar. A stronger dollar means foreign sales are not worth as much when converted into the greenback for reporting and the company has booked a year-over-year decline in sales three of the last five quarters.
But against this cyclical weakness, Monsanto management is making the tough decisions to protect cash flow and plan for the future. The company recently announced a restructuring to cut labor costs by 12% and result in $575 million in annual savings over the next two years.
Current plans are based on a modified forecast for corn demand and crop prices, one that could prove to be extremely conservative when the market returns to its long-term trend.
Monsanto Stock Fundamentals
Sales have weakened over the last year but the company has managed to cut costs in-line with revenue. Costs on the new restructuring plan will hit results over the next few quarters but operating margin should start to rebound significantly by mid-2016.
Monsanto is one of the more leveraged companies in its industry with half the capital structure in debt. The company has managed current liabilities well and there is no threat to liquidity. Bonds carry an A-rating by Morningstar and debt maturities are spread fairly evenly through 2025.
Monsanto maintains its innovation lead by spending more than $1 billion a year in research & development. The drop in cash flow from operations has been amplified for a larger drop in free cash flow without cuts to capital spending. Even in the current weakness, the company has managed to generate $1.6 billion in free cash flow over the last four quarters.
Monsanto Dividend and Growth
The plunge in shares has improved the dividend yield to 2.4% from an average yield of 1.7% over the last five years. The payout ratio has remained steady at 36% but may need to be increased to maintain regular dividend increases which have grown at a rate of 13.4% over the last five years.
Monsanto has paid a dividend since 2001 and has increased its payout for 13 consecutive years. Management has taken advantage of lower prices to aggressively buy back shares, repurchasing $6.8 billion over the last four quarters. As part of the restructuring plan, the company will accelerate its share buyback program with another $3 billion repurchased over the next six months.
Monsanto Stock Valuation
After the selloff on the share price, Monsanto is trading at just 16.1 times trailing earnings and well below its five-year average multiple of 24.9 times earnings. Analysts expect reduced earnings this year of $5.38 per share before rebounding next year to $6.48 per share.
The grain market may take a couple of years to rebound but Monsanto doesn’t need another boom cycle to turn its shares around. The company is on track to release its next generation of Roundup Xtend system next year and profitability should improve by the middle of the year. The company still generates strong cash flow and is planning on returning a lot of that cash to investors.
I’m not quite as optimistic on next year’s earnings but even at $6 per share, the stock price comes down to less than 15 times earnings. The aggressive restructuring plan, share repurchase and long-term demand makes it easy to like shares for a buy recommendation.
Shares of U.S. companies have soared since 2009 and represent nearly 50% of the global market capitalization for equities everywhere. As other markets languish, still struggling to recover from lingering effects of the financial crisis, foreign exposure in your portfolio can be a tough case to make.
But you might want to take another look at stocks of foreign-based companies.
Exposing your portfolio to other economic cycles can help to diversify the coming rate increases in the United States. Foreign companies often pay higher dividend yields than their U.S. counterparts, some countries like China and Russia ‘encourage’ companies to pay out more in dividends to help stimulate the economy.
The best reason though could be as simple as valuation. The surge in U.S. markets has vaulted the S&P 500 to 20.7 times trailing earnings, well above the long-run average around 16 times earnings. Shares of foreign companies offer much cheaper valuations, stable cash flows and some very persuasive dividend yields.
And three of my favorites are best of breed in their segments.
Potash Corporation of Saskatchewan (NYSE: POT) is the world’s largest fertilizer company by capacity, controlling 20% of the global potash market and third largest market share in nitrogen and phosphates. The pricing system for potash was turned upside down in 2013 when companies stopped agreeing to a price-based system where production was limited to support prices. Prices fell by more than 25% as some companies have lifted production and lowered prices.
Shares of PotashCorp plummeted from $40 per share to $30 and have continued falling this year to around $26 per share. While I won’t attempt to call a return to the pricing system for potash, fundamentals are stable at PotashCorp and the lower prices are keeping competition out of the market.
The company has lifted free cash flow to $1.5 billion over the last two years and has more than enough to protect the 5.7% dividend yield. Shares are trading at 14.4 times trailing earnings which have stabilized and are expected to be higher by 10% next year. An ever-expanding global population will require an increase in food production and crop yields, and that is only going to be possible through higher fertilizer use in agriculture.
Bank of Nova Scotia (NYSE: BNS) is the third-largest bank in Canada with more than $600 billion in assets. Shares have been rocked by the selloff in oil prices as investors fear the bank’s oil & gas commercial clients will leave it on the hook for defaulted loans. Shares have tumbled 33% since July 2014 and are trading at the lowest since February 2010.
The bank has operations in 55 countries with business in retail banking, wealth management, insurance and capital markets. Loan growth in Latin America was reported 12% higher in the third quarter compared to the same period last year and the domestic Canadian market is partially protected by high regulatory fees. Management reported no significant impaired loans in the third quarter though I do believe some might start showing up towards the beginning of 2016 when price hedges stop supporting many explorers.
Fallout from lower oil prices may eventually lead to defaults but the bank has been moving money to its provisional account for future losses. The international and segment diversification will ultimately smooth earnings and investors earn a 4.9% dividend yield to wait out any weakness. Shares trade for 8.6 times trailing earnings, a discount of 41% on the 14.9 times multiple for the Financial Select Sector SPDR (NYSE: XLF) of American financials.
Diageo PLC (NYSE: DEO) is the world’s largest producer of premium liquor with some great brands like Johnnie Walker, Smirnoff, Crown Royal, Captain Morgan and Bailey’s. It owns 14 of the top 100 global distilled spirits brands and 7 of the top 20 brands. The company also competes aggressively in the champagne market with a 34% share and in beer and wines.
Shares fell more than 8% over the week to August 25th on the Chinese devaluation as investors worried that the premium liquors would be too expensive for Chinese consumers. China is less than 5% of the company’s business. While the Chinese market still holds potential, it doesn’t look like the devaluation will do much more than cause a few ripples for the company.
By an accounting convention of valuing inventory at cost, the company could be undervalued by more than five percent. Much of the company’s product, costing relatively little to produce, is aged for many years before selling for a huge premium. Valuing this inventory at cost undervalues the company’s assets.
Beyond the inventory discrepancy, shares are very attractive compared to peers. Shares trade for 18.9 times trailing earnings, a 35% discount to the valuation on competitor Constellation Brands (NYSE: STZ). Premium liquor sales are a little more cyclical than beer and shelf liquor, so the company can expect to see some weakness in a recession. Still, as a vice stock, liquor doesn’t face the same consumer backlash seen in tobacco companies and sales are almost certain to grow between 2% and 4% a year over the long-run. Investors earn a 3.25% dividend yield and strong upside potential in the shares on valuation.
Companies in the S&P 500 book just 33% of their sales outside the United States. The U.S. economy, once the economic engine of the world, now only accounts for about a fifth of the world’s economy. I’m not saying you need to rush out to overweight your portfolio with foreign companies but U.S. investors tend to be extremely underexposed to international stocks. Take advantage of cheaper valuations and strong outlooks to bank some persuasive dividend stocks and upside price potential.
There are just as many ways to pick dividend stocks as there are stocks themselves and an entire book could be written on the subject. I have seen every screen and every method with some as simple as looking for cheap value and others as complex as large computer programs.
Fortunately, there are a few concepts that have stood the test of time and are basic enough that anyone can understand them. Our hope is that you will become a better dividend investor by getting a firm understanding of these concepts.
Understand the business
One of the most adept investors of our time, Warren Buffett of Berkshire Hathaway, holds to the most basic and intuitive investing idea. Understand the business and invest as if you were buying the whole company.
Many investors throw their money at hundreds of stocks without any research at all, hoping that the winners will compensate for the losers. They see breaking news or read a short article in the financial press and figure, “why not? It’s only a few thousand dollars.” They end up with a portfolio that is not aligned with their return needs and never meet their financial goals.
An investors only needs 30-40 stocks for a diversified portfolio and maybe fewer if they invest in funds that hold many companies themselves. By investing in fewer companies, an investor should have the time to do research and understand the business.
When Warren Buffett says he invests his company’s money only in businesses the board can understand, he isn’t talking about hiring NASA scientists to be able to understand a complex business model. If a business is so complex or subject to constant change that the average business person cannot understand it, then it won’t be in the Berkshire portfolio.
This is why you find names like Coca Cola (KO), Johnson & Johnson (JNJ) and Walmart (WMT) in Buffett’s portfolio. They are relatively simple business models and almost none compete in multiple industries. They sell one product or service and they do it very well.
One of the most important concepts of understanding a company’s business is being able to assess its competitive advantage in the industry. This has a lot to do with understanding the industry or sector in which the company operates which is why Buffett invests most of the portfolio in just a few sectors like consumer goods, financials and utilities.
A good start to understanding an industry is by analyzing Porter’s Five Forces model of competition. The model includes five traits of competitive forces. If you can answer the five questions for the industry as well as the company in which you might invest, then you know the business.
How much bargaining power does it have with its suppliers?
If the company is a large buyer or one of the few that buys a particular product, it will have more bargaining power with suppliers. Similarly, if there are many individual suppliers for the same product then the company will be able to choose whichever offers the most attractive terms.
The companies in Warren Buffett’s portfolio all have a dominant share of the market in their industry. That means they have more bargaining power on suppliers because they are generally the largest buyers in the market. They can get better price or credit terms and can demand better quality for the supplies they purchase.
How much bargaining power does it have with its customers?
This question shares the same ideas as the previous but from another perspective. If the company is one of only a few that sells a product or if there are many individual customers, then it will be able to demand higher prices without worrying about losing a few customers in a pool of many.
All the companies in Buffett’s portfolio have incredibly strong brands and customer loyalty. They sell things that people want to buy over and over or provide the services that customers cannot live without. This means they can increase their prices without being afraid that their customers will go to a competitor. This kind of customer loyalty and brand identity is usually a product of decades of marketing and customer satisfaction, which is why you’ll find few start-ups in Buffett’s portfolio.
Is there a constant threat of new competition in the industry?
This is one of the most important questions for an industry or company. The constant threat of new competitors will force a company to cut prices, increase advertising and will generally lower profits. Companies in the industry can avoid this by having a size or patent advantage that protects them from new entrants.
The companies in which Warren Buffett invests are all in relatively protected industries where there are strong barriers to entry. Within the utility sector, these barriers are legal and many of the companies have a monopoly in their market. In other sectors, the costs of production and marketing would be so high that only multi-billion companies could enter the market. Take Coca Cola and the soft-drink industry for example. There are just a few large competitors in the market and each has a very recognizable brand and strong customer loyalty. A new competitor would not only need massive production facilities but would need to spend hundreds of millions in marketing to break into the industry.
What is the rivalry among existing competitors?
Competitive rivalry within the industry shares a lot of the same ideas as the threat of entrants and can be a double-edged sword for a company. If there are many competitors selling a relatively similar product, competition will be high and profits will be low. If there are only a few competitors and competition is low, profits will be higher but it could attract new companies into the industry. The best scenario, and one in which many of Buffett’s companies find themselves, is an industry with only a few competitors but highly competitive between them. That way, the fewer competitors can more easily control the market and avoid a price war between companies but modest profits do not necessarily attract new competitors.
Is there a threat that another product can substitute for the company’s product or service?
Substitute products can be just as bad as new competitors in the industry. Some industries like soft-drinks may have many possible substitutes within the beverage category. Other industries, like water utilities really have no substitutes.
Some companies in Buffett’s portfolio have found a way around substitution by offering all the substitutes themselves. Coca Cola not only sells soft-drinks but also has it own line of bottled water and juice drinks. This allows the company to worry less on one individual product and focus on a product category. Coca Cola can use its size and brand strength to dominate the entire beverage category instead of just carbonated soft-drinks.
Fundamental analysis refers to looking at the financial data provided by the company to assess its strength relative to competitors and its prospects for future growth. As with any kind of stock analysis, there are a million and one data points to look at but a few basic ideas are all an investor needs to pick good companies that can provide a steady income and price returns to a portfolio.
Valuation multiples are some of the most closely followed fundamentals. We will cover them in the next section so will not spend too much time here. These measures are usually a comparison of the stock’s price with another fundamental factor like earnings, sales, cash flow or enterprise value.
Margins are an important metric to follow, especially a company’s margins relative to peers. The three margins from the company’s income statement are:
Gross margin is the percentage of sales left over after paying for the cost of materials.
Operating margin is the percentage of income left over after all operating expenses have been taken out of sales. This is one of my favorite fundamental metrics because it shows how well management operates the business, growing sales while keeping operating costs under control.
Net margin is the percentage of income left after taking out all income statement items from sales.
Dividend yield is obviously extremely important for a dividend portfolio. Since the general market offers a yield of around 2%, I like to see yields above 2.5% for my dividend stocks to show management’s commitment to returning cash to shareholders. I also like to see a payout ratio of 75% or less, though 65% or less is even better. If a company is paying out more than 75% of its income as dividends, it may have a tough time increasing the dividend payment without a strong boost to income or may even have trouble maintaining its dividend if sales decline.
While past performance isn’t a guarantee of future returns, history is usually a good guide of management’s ability and the company’s commitment to returning cash to shareholders. I have developed a proprietary system, the historical performance rating system, which ranks companies on a series of dividend and performance-related factors.
The system looks for dividend yields between 2% and 20%, for a range that can put a meaningful amount of income in your pocket but is not so high as to be primed for a dividend cut. Free cash flow yield, the free cash flow divided by the stock price, is an important metric because it tracks the company’s ability to pay its dividend.
Dividend growth is the most important factor in my model with only those increasing their dividends by more than 7% over the last five years receiving a top score on the scale. The system also measures income growth over the previous three years and looks for companies with a payout ratio of 65% or less.
While I have a laser-focus on dividends, no investor can ignore price return so the system also tracks the twelve-month return for stocks. Collecting a sky-high dividend is a hollow victory if the price of the shares falls to the basement.
I have incorporated many of these factors in the dividend stock screener on the DividendLadder website. The screener allows you to search separately for dividend stocks, REITs or MLPs. Within each category, you can screen for the price-earnings ratio, yield, free cash flow yield, dividend growth, income growth, payout ratio, one-year return and the HPR rating.
Valuation of stocks seems like it should be one of the simplest and most intuitive concepts in investing. Buy low and sell high is the simple mantra. It is rarely as simple as that and there are many different models by which to measure a stocks fair value and its value relative to peers.
The first, and probably the most commonly used, metrics are price multiples. These are simply the share price divided by another per share amount. Common measures are by earnings, sales, cash flow or book value. The price-to-earnings ratio (P/E) is the most common of the group and makes sense because earnings are supposed to measure the profit to owners of the company so the ratio measures how much investors are willing to pay for each share of those profits.
There are two important concepts you need to remember when using price multiples. One is that the multiple can be compared to competitors and their current multiples or to the company’s own stock history. Are the shares relatively expensive or cheap compared to other companies or to its longer-term average?
The other important concept is that the price multiple is a relative valuation method. It measures the stock’s price against itself or another stock using the same measurement.
Price multiples will not tell you what the fair value of a company is or how much you should pay for the shares. The fact that a company’s shares trade for 15 times its earnings may mean that it is relatively cheaper than a stock trading at 20 times earnings but that does not necessarily mean it is a good buy. The stocks in the sector or even the whole market may be overvalued so buying the cheapest ones may still be paying too much.
Comparing a stock’s P/E multiple with its own average over a longer period may help decide whether it is over- or under-valued but investors will need to use other methods to determine fair value. Further, understand the differences between the price multiples. Because earnings can be easily manipulated by carrying forward or delaying expenses, the price-earnings multiple may not be the best method. Price to some kind of cash flow is usually a cleaner ratio but also has its limitations.
Many dividend investors prefer a dividend yield method of valuation. Since income is the focus of the portfolio, it stands to reason that it should be used as a decisive point whether to buy a stock or not. The idea makes intuitive sense as well. The dividend yield is the current payout divided by the share price so if a stock’s share price has outgrown its value then the yield would be relatively low and may not make the cutoff.
Many investors measure yields by sector and by the company itself. If an investor just set an arbitrary dividend yield across all stocks, then their portfolio would be overweight certain sectors like financials and utilities. The portfolio would miss out on growth in other sectors and leave risk for a big loss if challenges arose for specific sectors. Within the sector or industry itself, compare the dividend yield with peers and with the company’s own history for a more robust measure of current valuation.
Another popular valuation method, and one that helps determine a fair value for stocks, is the discounted cash flow (DCF) approach. The method requires some calculations and an understanding of cash flows and cost of capital so you may need to spend some time researching the procedure. An example will help understand the basics.
DCF valuation always starts with analyzing the company’s ability to grow dividends in the future. I have used two growth periods in the Walmart example above but you can use one or any number of periods. The dividend growth rate is based on historical growth and your assessment of the future cash flows. On a historical growth rate of 14% but estimates for slower growth in profits, I estimated that the company would be able to grow its dividend by 12.5% annually for the next five years and by 10% annually for the five years after that. You also need to estimate a rate of growth that the company can maintain into perpetuity. This should realistically be close to the natural rate of growth in the economy but opinions vary. My own estimate was for a 4% terminal rate of growth. The calculations are not shown but each year’s dividend is increased by the assumed rate of growth.
Next, you need to estimate the cost of capital for the company. In finance terms, the cost of capital is the required return to go forward with a project. If the returns on the project to not meet or exceed its interest rate cost then there is no sense making the investment. The rationale is the same with investing in a company. The future value of cash flows should be discounted by the cost of the company’s capital structure. This means finding the company’s relative cost of equity and the cost of debt and then weighting them by the amount of debt and equity used to finance the company.
Walmart issues 10-year debt at 3.4% and uses it to finance 42.6% of the company. The cost of equity, found by using the Capital Asset Pricing Model or some other approach, was estimated at 5.8% and weighted with the remaining 57.4% of the capital structure. The calculations are not shown but each year’s dividend is discounted by the cost of capital and the appropriate years to the payment, i.e. a series of discounted cash flows. This is done to find a present value of each year’s cash flow. Once all the present values are added up then you will have an estimate of the fair value of the shares in the market today.
It is a complicated procedure but very popular because it can help you find a justifiable price to pay for stocks. You will probably need to read into each part of the process before you are comfortable with the method but it is well worth it. An important note is that the model is highly dependent on the assumptions you make for dividend growth and the discount rate. Depending on your tolerance for risk, you might make your assumptions and then lower the growth rate or increase the discount rate slightly for a more conservative estimate of the share price.
The ultimate value of a stock is the future growth and cash flows you will receive so forward expectations are another important valuation concept. Spend enough time researching a company or an industry and you will get a good feel for what is possible as far as margins and sales growth. Along with a perspective on growth in the general economy or other macro-level drivers and you can start to build your own estimates for earnings or cash flow growth at a company. It is a formidable task and even Wall Street analysts do not do it alone. Look at estimates for economic growth and expectations for the company itself from several analysts. This can help guide your own expectations.
I would caution you on relying too much on analyst or market expectations. Two problems exist with Wall Street’s expectations for earnings and stock prices. First, many analysts need to protect their relationship with company management to have access for interviews and so the banking division of their own company might do business with the subject company. This usually leads to optimistic assumptions and estimates and few recommendations to sell a particular company are ever issued.
Another problem is the natural optimism that seems to pervade the markets. Few ever expect the economy or earnings in the market to plunge until they actually do and a recession occurs. People generally forecast a continuing rise in economic growth and corporate earnings into the future. Investors need to look at the facts objectively and decide if they want to build in a little more conservatism into their own expectations.
While most people use relative valuation methods like the price-earnings multiple based on earnings over the last twelve months, you will also see this multiple based on forward earnings expectations. That means making an estimate for earnings over the next year and then dividing the current share price into that estimate. The problem is that many investors use forward expectations and price multiples as a way of rationalizing high current prices. They reason that, though the price multiple on the previous year’s earnings is high the price multiple on next year’s earnings is reasonable so the stock is still a buy. The problem with this is forward expectations tend to creep up until the current stock price is justified. When the inflated expectations are not met, the stock doesn’t seem like so great an investment.
There are more than 1000 publicly listed companies that trade on the New York Stock Exchange, the Nasdaq and the American Stock Exchange that pay dividends. In fact, the list of dividend-paying stocks is so large and diverse that your biggest challenge is going to be choosing the best for your portfolio. Fortunately, dividend stocks can be categorized to narrow the field of options for your own investment needs. The groups are not exclusive, so some companies may be in multiple categories.
Dividend Growth Stocks
Companies that have consistently increased their dividend payment have not only outperformed the general market, but they often do so with less risk. That is why many investors look specifically for companies with strong cash flow and a commitment to returning cash to shareholders.
Dividend Aristocrats is a term often used for a group of stocks that have consistently increased their dividend payment per share over a certain period. The most well-known is the S&P 500 Dividend Aristocrats, composed of the largest U.S. firms that have increased their dividend every year for at least 25 years. To March 2014, the S&P 500 Dividend Aristocrats posted an annual return of 10.3% over the last ten years compared to a return of 7.4% for all the companies in the S&P 500 over the period.
Because of the requirement for consistently increasing dividends over a long period, the group tends to be over-weighted to a few sectors of the economy. Shares of consumer staples companies make up nearly 25% while shares of technology companies make up less than 2% of the index. Based on current trends those numbers could change over the next 10-15 years. Whether you invest in a fund replicating the Aristocrats or just use the index as a source for potential investments, the list is a good place to start when trying to find strong dividend-paying companies.
Some stocks pay dividend yields so high that it seems like an easy decision. Unfortunately, like that notorious offer you can’t refuse, you are better avoiding some of these stocks. There are two issues you need to be aware of when searching for high-yield dividend stocks.
First, is the high dividend yield simply a function of poor price performance? If the shares pay an annual $0.25 per share dividend and have a price of $15 per share, the dividend yield is just under two percent. Now if the price of the shares plummets to just $2.50 per share, the dividend yield vaults to 10%. Of the 181 stocks trading on the NYSE with dividend yields over 8%, nearly half (81) have seen their stock price fall by more than 8% over the past year with the top ten posting losses of more than 20%. A dramatic price drop is usually a sign of tough times for a company and the dividend may have to be cut to protect the business.
Another reason you need to be cautious of high-yielding stocks is that many of these companies keep little back for growth. They pay out nearly all their cash as dividends and must constantly raise money for new projects. Dividend payments from these stocks are usually extremely inconsistent with very high payments in some quarters and low payments in others. That high yield you think you are getting may not be so high in the near future.
Despite the risks, some companies do a very good job of paying a high dividend yield and still protecting future growth. We will discuss more about how to select stocks in the next section. For now, just remember that the stock market is like anything else. If it looks too good to be true, it probably is.
Shares of utility companies are popular with dividend investors because of their consistent payments and low risk in the business model. Utilities are a special type of company, with a sort of protected status. They trade the ability to increase rates as high as the market will bear for the protection of being one of the few suppliers. This also makes them one of the most predictable returns in the market.
Within the group, investors generally categorize companies by the service provided (electric, water and natural gas) or by whether the company is regulated by a local municipality or not. Each category will mean different risks and rewards. Unregulated providers may be able to raise rates more quickly but will probably not enjoy monopoly protection from competitors. The different service providers may be at risk to prices or shortages for their respective commodity.
One risk to utility companies that you will want to watch out for is increasing interest rates. Since the power of the company to raise rates is often limited, their cash flow and dividends are relatively fixed compared to other stocks. This means that the investment may behave more like a bond than a stock and the share price may fall when interest rates rise. The drop is usually not too bad with a gradual rise in rates and the safety and yield in these companies is still pretty enticing.
Companies providing staple goods, or things that are seen as necessity products, are also a common favorite for dividend investors. Like utilities, these companies are typically in very mature industries with stable sales and cash flows. Since sales are so consistent and opportunities for growth are relatively fewer, these companies can afford to pay out more cash as dividends.
Consumer staples may also be referred to as consumer non-cyclical because their products are not generally prone to the rise and fall of the business cycle. Within the group, you find industries like: Beverages (both alcoholic and non-alcoholic), food processors, personal & household products, and tobacco. While you may not agree that alcohol or tobacco products are necessities, those that buy the products generally buy a consistent amount through good times and bad and the companies’ sales are relatively consistent.
New Breed of Technology Dividend-Payers
Just twenty years ago, no one would expect a technology company to pay a dividend on its common shares. The tech bubble was just inflating and companies like Oracle (ORCL) and Intel (INTC) needed every penny to pay for their tremendous growth. Talking about how a new era has begun just makes me feel old but there is a growing list of tech giants that are paying strong and sustainable dividends.
Slowing opportunities in growth projects and a huge stockpile of cash has driven some of the bellwether technology names to issue dividends over the last few years. Microsoft (MSFT) started paying out cash in 2003 and Intel offers a yield stronger than many of the consumer staple companies. While growth might have slowed for these companies in developed markets, many still have longer to run on emerging market convergence. Economies of scale mean they can acquire new startups to help drive sales growth as well.
Of course, dividend payments are still the exception rather than the norm among tech companies. Of the approximate 1,800 technology companies listed on the U.S. exchanges, only 219 pay a dividend and only 105 offer a yield of 2% or higher. The addition of dividends means a strong complement to shareholder returns and a great way to diversify your portfolio from the traditional dividend-paying sectors.
Dividend Exchange Traded Funds
Mutual Funds have been around for nearly two centuries but their publicly-traded counterpart, the Exchange Traded Fund (ETF), is still a relatively new concept for some investors. ETFs are basically mutual funds that can be bought and sold like a regular stock. The funds hold a collection of investments, usually stocks in other companies, and sell their own share ownership. ETFs have a defined investment mandate that guides the kinds of investments they hold and can offer a way for investors to buy a diversified basket of stocks with one purchase.
There are more than 40 funds with a defined dividend strategy and hundreds of others that pay dividends. Most dividend-focused funds pay between 2% and 5% but there are also those with higher yields. One of the most attractive benefits of dividend investing through ETFs is that it opens your portfolio to assets and stocks in which you might not otherwise have access like bonds and foreign companies.
Investing in ETFs can be similar to investing in stocks but there are also some important differences that you need to watch. First, while fees are normally lower than investing in mutual funds, you will be charged a percentage of assets every year. The fee is fairly small for most funds but can be high for some actively-managed funds. You may also be concentrating your portfolio and do not even know it by combining some funds with the rest of your stocks. Since most funds invest along a specific idea or mandate, often their holdings will not be well-diversified across sectors or industries. Combine a portfolio of high growth stocks with a biotechnology ETF and you could be getting a lot of the same stocks.
Monthly dividend stocks
What is better than getting your dividend checks every quarter? Getting your dividend checks every month!
A few companies, mostly finance and REITs, pay dividends on a monthly basis. The fact that payments go out twelve times a year instead of four does not necessarily mean the yield will be higher but getting frequent payments may help to smooth out your income if you rely on your investments for extra cash.
The list of funds that pay dividends monthly is fairly extensive and might be a good place to start for those looking for monthly payments.
As for real generational wealth, there are few assets that have made more people rich than real estate. A survey by Fidelity notes real estate as the top source of generational wealth and more than three-quarters (77%) of millionaires own property. Not only does ownership provide long-term returns through appreciation and rents but also an attractive tax shield from the deduction of depreciation.
Until the 1960s, this asset class was largely the domain of the rich with pockets deep enough to diversify themselves across different property types and different regions. Then President Eisenhower signed the REIT Act into law and a new world of investment was opened to people like you and me.
REITs hold and manage real estate property and issue shares on the stock exchanges. If the firm passes at least 90% of profits to investors it does not have to pay corporate income taxes so it is an extremely tax-efficient way to manage assets. Without the millions to diversify across different property types and geographic locations, REITs are the best way for retail investors to get access to the market.
And besides the benefit of diversification into another asset class, REITs have provided great returns over the long-term. The National Association of Real Estate Investment Trusts (NAREIT) monitors sector returns and shows that its index of equity REITs has outperformed the S&P 500, the Russell 2000 and the Barclays Aggregate Bond index in the 10-, 20- and 30-year time horizon. In fact, over the forty years to 2010, the NAREIT index has provided annualized income returns of 8.3% and an annualized price return of 5.5%.
As with other fund investments, a REIT usually follows a mandate as to the types of property it holds. Investments are usually built around a property-type or a geographic location. Different property types offer different investment characteristics due to different supply and demand throughout the economic cycle. There are primarily four commercial property types: office, retail, industrial and multi-family. Combine these types with a vast array of geographic mandates and you can start to see the opportunity to invest in real estate in almost any market.
In a recent twist, not all REITs necessarily operate real estate. Though the IRS may change the rules in the future, there are a handful of companies that have been granted REIT-status for tax purposes but in industries like: data-storage, cell phone towers and mortgage notes. Most REITs pay a dividend yield between 3% and 5% though some that invest in mortgages offer much higher yields at higher levels of risk.
Like ETFs, REITs trade like regular stocks but there are a few differences that you need to remember. Since real estate is a depreciable asset, there is often a huge expense on the income statement for REITs. This reduces earnings per share but unlike machinery, most real estate actually increases in value with age, so the earnings reported by the company may not be a good measure of the stock’s value. To measure REITs, investors use Funds from Operations (FFO) which adds back depreciation and deducts other property-related sales. FFO for REITs is used like earnings to measure how expensive or cheap the stock is compared to peers and history, i.e. price-to-FFO.
REITs are more heavily exposed to rising interest rates than other stocks for several reasons. Because rent increases may be fixed for long contract periods, the cash flow from REITs is much more like a bond investment. When interest rates increase, the value of bonds decrease because the fixed coupon payment is less attractive against higher-yielding investments.
REITs may also be exposed to rising rates because of high financing costs needed to run the companies. Since they pay out almost all of their income every year, REITs finance growth through loans or by issuing shares. When the cost of debt increases as rates rise then the companies might issue shares instead and current shareholders could see their ownership diluted.
While REIT weakness when rates rise might be true in theory, history has shown that it is really only a problem when interest rates increase quickly over a limited period. Generally, the companies are able to manage their rate exposure and still provide solid returns to investors.
Master Limited Partnerships are another unique structure of business to take advantage of taxes on certain investments. Companies that own certain assets, primarily oil and gas transportation and storage infrastructure, are allowed to pass on their expenses and profits to owners without paying corporate income taxes. The opportunity to avoid double taxation, at the corporate and individual level for other companies, is a huge advantage and many oil & gas conglomerates spin off their infrastructure assets and pay a transaction fee to the partnership for pipeline or storage needs.
There are two types of MLP owners, the general partner and the limited partner. The general partner operates the company and usually owns some of the limited partner shares as well. The limited partner issues shares that trade like regular stock and pays a distribution from cash flow. Since fees are based primarily on the volume of energy products through pipelines or in storage, the partnership’s cash flow is not as exposed to commodity prices as with other energy companies. Owners of shares in the limited partnership are technically called “unitholders” instead of stockholders.
Previously, the pipelines and storage were seen as relatively mature industries and growth was relatively weak. With the boom in U.S. energy production, these companies have seen a huge rise in demand for traffic along their infrastructure and have ramped up capital spending to increase the size of their network.
MLPs tend to offer higher yields than REITs or other dividend stocks, usually around a range of between 5% and 7% a year. As with all dividend investments, it is important to watch the yield and the company’s ability to sustain a higher dividend payment. A special metric is used for MLPs called Distributable Cash Flow (DCF) and is similar to FFO for REIT investments. DCF is the companies operating earnings (EBITDA) with capital expenditures added back to arrive at a measure of the cash available to pay out distributions.
The coverage ratio is just the DCF divided by the current distribution and is a strong tool to measure how well the partnership can sustain or grow distributions, i.e. if the partnership is paying out more than its DCF (a coverage ratio above 1.0) then cash flow will need to be increased or the distribution cut.
As with REIT investments, MLPs pay out a lot of their income as distributions so they may issue shares or debt to fund future growth. Shares issuance will dilute current investors while too much debt means higher rates and less distributable cash flow after interest expense.
Beyond the tax-advantaged status at the corporate level, individual investors receive a tax break as well. Many distributions are not classified as income, but as a return of capital. The distributions reduce the cost basis in the investment and are not taxable until the asset is sold. Once the investment is sold, a portion of the difference between price and cost basis is considered long-term capital gain and the rest is taxed as income. That means that you only pay taxes on much of the dividends when you sell the shares.
Of course, these benefits come at a cost. MLPs issue a K-1 tax document each year that details the profits, expenses and distributions in the partnership. As a unitholder, you will need to file a special form for these investments on your income tax returns and keep track of your basis in the shares.
A dividend reinvestment plan (DRIP) is an offer by a company or brokerage account that allows you to automatically buy additional shares with your dividend payments. Rather than cash deposited in your account on the payment date, you will receive new shares in the stock.
DRIPs and advantages
There are really two advantages of DRIPs. First, there are usually little or no fees in reinvesting your dividends. Depending on how much you normally pay to buy shares, this could be a big discount over time. Some companies even offer a discount on the share price for reinvested dividends. Most programs allow you to buy fractional shares as well so you do not have to wait for your dividends to be reinvested in a whole share.
The biggest advantage of DRIPs is the effect of compounding returns over time. Each share or fractional share that you buy with your dividends is a larger ownership in the company and means more dividends in the future.
Remember that 100 shares of Coca-Cola Company? Reinvesting the $30 quarterly dividend may not seem like it could amount to much but over decades it could mean a portfolio several times larger. If you had invested $10,000 in Coca-Cola shares in 1964, the difference between reinvesting or not is more than one million dollars!
Don’t think you have to hold shares for decades to see the benefits of a DRIP. An investment in shares of Johnson & Johnson (JNJ) over the two years to April 2014 with dividends reinvested would mean a return 3% higher than if dividends were just held in cash and an extra $230 in your account.
Potential disadvantages of DRIPs
Dividend reinvestment is not without its disadvantages. You are essentially putting more of your eggs in one basket with a constant reinvestment into the same company. This could set you up for an unbalanced portfolio and big losses on if that company ever falls on hard times. Reinvestment also means that you will not be able to use that cash for current spending needs or really to decide what you want to do with it.
Reinvestment plans can be stopped at any time so the disadvantages may not be as permanent as they appear. Many plans even allow you to only reinvest a portion of the dividends instead of the full amount.
Setting up your dividend reinvestment plan
Whether you have all of your investments in one particular brokerage account or with individual companies, setting up a dividend reinvestment plans is usually straight forward and simple. For your investments held in a brokerage account, call the customer service line and ask which shares offer DRIPs or if you can enroll your entire account at once. Even if a particular company does not offer a DRIP, your brokerage may offer the service.
You can also go directly to the company to see if they offer a DRIP for shares. Contact the company’s Investor Relations or Shareholder Services department. They will be able to tell you how to enroll for the program as well as any fees or discounts.
I do not think it is excessive to say that dividends have fascinated investors since the first payment was made to owners of the Dutch East India Company over 400 years ago. While the promise of price appreciation is a strong draw to the markets, seeing that regular payment in your account is a great feeling.
Recent events in the market have only made dividend-paying stocks even more popular. With interest rates at historic lows and bonds paying little above inflation, investors have found new hope for income in shares of companies with healthy dividend yields. More so, after seeing their portfolios halved in two market busts in less than 15 years, investors are embracing dividends as the only certainty in meeting their financial goals.
History of dividends in the stock market
Though investors have been reaping the dividend rewards of ownership for centuries, we will focus primarily on the domestic U.S. market for our study of dividend returns. Dividends from stocks and assets of foreign-domiciled countries are an important part of a diversified portfolio but can be accessed through American Depository Shares (ADRs) traded on the domestic exchanges.
Though the contribution varies, dividends have been an important part of total returns for investors. The graphic below shows the contribution of dividends and capital appreciation to monthly total returns of the S&P 500 for each decade over the last 70 years and for the 86 years to 2012. Dividend payments have contributed a third of total stockholder returns over the longer-period and there is evidence that they may contribute more of returns in the future. The graph excludes data from the 2000s where, due to two market crashes, dividend income comprised more than 100% of the total return.
The lower contribution of dividends in the 90s is a function of the internet stock bubble which didn’t burst until the year 2000. Including the two decades around the internet bubble would show a much larger contribution from cash payments and less from runaway stock prices.
As companies continue to hold more cash on their balance sheets and find fewer suitable growth projects, dividends could increasingly offer higher contributions to total return. Economic growth in the United States and across the developed world is struggling to reach 2% a year. Stagnant wage growth and persistently high unemployment is constraining consumer spending. Without opportunities for organic growth, through higher sales, companies have turned to buying back their shares to increase their earnings per shares outstanding.
Total dividend income jumped 9.7% in 2012 and 2.9% in 2013 as companies returned more cash to owners. Share buybacks of $500 billion amounted to nearly as much as dividends in 2013. Even this was not good enough for some activist investors like Carl Icahn who has taken active management roles to force cash returns at companies like Apple (AAPL).
Not only are dividends an important part of total return, but Americans are increasingly relying on dividend income for their everyday needs. Data from the Bureau of Economic Analysis shows wages and dividends as percentages of total personal income over the three decades to 2013. Wages and salaries have sunk to just half of total personal income while dividend payments have grown to more than 5% of the total. In fact, more than $757 billion was collected from dividend payments in 2012. There are several reasons behind the growth in dividend income and many of them point to a yet higher dependence on dividends in the future.
Some of the increase in dividend income over the last decade is a result of the growing popularity of dividend investing with retail investors and the need for consistent returns after tough market crashes have wiped out years worth of appreciation.
As the general age of the population gets older, they rely more heavily on their investments and specifically on dividends for their financial needs. Wages become a smaller share of income as your portfolio grows and spins off more income every year. There are two important ideas here that should make dividend investing a core part of everyone’s investing strategy.
First, as the 76 million baby boomers age, they will increasingly look to the safety and income of dividend-paying stocks. We’ve already seen a shift in market demand to these stocks but I believe it will only get apparent over the next decade. This continuous demand for shares of these companies could propel the prices consistently higher, meaning high returns to price appreciation on top of a dividend yield.
Looking at the graph, another huge advantage of dividend investing should become obvious. Look at the graph not as the components over time but over your lifetime. As a young investor, you are relying heavily on your salary to pay the bills and dividend income is probably relatively small. Over the years, as your portfolio grows, dividend income grows and becomes a larger part of your total income. Dividend investing can help you reach the financial freedom to depend less on wages and more on the fruits of your labor.
The Power of Dividend Stocks and Compounding Returns
Perhaps the strongest evidence in favor of dividend investing is the actual returns in the market. The graph below shows the annual compound return to four groups of stocks in the 37 years to 2010. Shares of companies that paid dividends but did not regularly raise their payments provided investors with a 7.1% annual return over the period, well above the 1.8% annual return from companies that paid no dividends.
If this were not cause enough to start investing in dividends, shares of companies that regularly grew their dividend payments returned an annualized 9.3% over nearly four decades. In dollar terms, if you had invested $10,000 to a portfolio of dividend growth stocks in 1973, by 2010 you would have more than $268,500 in your account. Compare that to $126,500 in the portfolio of companies that paid dividends without regular payment increases and just $19,350 in the portfolio of non-dividend paying stocks. One important note is that these returns are dependent on reinvestment of dividends in the company. We will cover the advantages and disadvantages of dividend reinvestment plans in the next chapter.
The outperformance of dividend-paying stocks makes sense on a financial level. For a company to pay dividends, it must make a detailed projection of its cash flow and plan sometimes years in advance for sales and growth projects. For a company to cut its dividend to preserve cash is usually taken as a signal of weakness by investors so dividend policy must be very carefully planned. A dividend payment is a limitation on the use of free cash and helps discipline management.
Free cash flow is like a narcotic to management, clouding their judgment and often leading to overconfidence. Management sees all the money rolling in and starts to think about building their legacy through pet projects, executive perks, and billion-dollar acquisitions. A culture focused on increasing dividend payouts keeps management grounded and motivates them for growth and increased profit generation.
With management constrained by the dividend, they are only able to go with the most profitable projects and have to think twice before giving themselves the bonuses that their Fortune 500 colleagues get every year. Bonuses paid with shareholder money, your money!
An Alternative to Low Interest Rates and an Inflation Hedge
The Ten-year Treasury bond, the instrument against which all other bonds are priced, hit a record low of 1.39% in 2012. Inflation that year increased by 1.7% so the U.S. government was actually charging investors a third of a percent to hold their money each year over the next decade.
To me, that doesn’t sound like any way to meet financial goals!
Since the market uses the rate paid on risk-free treasuries to price other bonds, the yields on all fixed-income investments have come down to the point that an investor might have trouble meeting investment goals with a portfolio of bonds. Even corporate bonds only pay a 2.8% yield after accounting for inflation and with no prospect for price appreciation if held to maturity. Bonds will return their yield to maturity but many investors have rushed into higher risk investments without really understanding the true risks.
Enter dividend investing. Many companies, particularly the Dividend Aristocrats discussed later, have returned cash so consistently and are so financially stable that their shares can be a good alternative to bond investments. These companies, some paying dividends for more than a century, have stronger credit ratings than the United States government and have been able to consistently grow sales even in mature markets.
This is not to say that dividend investing should completely replace bonds in every portfolio but investors may have a hard time meeting income goals unless they increase the proportion of dividend-paying companies.
The table below shows the dividend yield and standard deviation (risk) on the list of popular income investments.
The data in the table should be used as an approximate to represent each group. Exchange Traded Funds were used to represent each group except the 10-year Treasury Yield. This was done for the availability of information on risk but the data may not be identical across all possible funds or portfolios in the group. For example, there are several funds available with a dividend stock objective and an innumerable amount of portfolios investors could construct with individual dividend-paying stocks. All will have different yields and risk characteristics.
The groups above were represented with the following funds:
Alerian MLP ETF (AMLP)
Vanguard REIT ETF (VNQ)
SPDR Barclays Capital International Treasury Bond (BWX)
Powershares Senior Loan Portfolio (BKLN)
iShares SPDR S&P 500 (SPY)
iShares Select Dividend ETF (DVY)
SPDR Barclays High Yield Bond ETF (JNK)
SPDR Barclays Long Term Corporate Bond (LWC)
iShares S&P National Municipal Bond Fund (MUB)
While dividend stocks have a lower yield than some of the bond groups, they offer the opportunity for price gains as well. Bond prices may even decline sharply on higher interest rates, eating into the dividend yield. All three bond funds shown above posted negative returns between 1.2% and 8.9% for the year to 2014. By contrast, the dividend stock fund saw its price surge by 20.2% over the period.
In fact, as rates increase closer to long-term averages over the next few years then bonds and bond funds could get hit even further. For an increase of just 2% in the rate on the Treasury bond, the price drops approximately 17% and losses would be felt across all bond investments.
Beyond bonds, you are not alone if you are looking at the table and thinking about reaching for higher yields through bank loans. The funds that hold bank loans in a portfolio have become popular in the low rate environment especially since most of the loans are variable-rate so will not lose as much when rates do rise. The problem with these loans is that, similar to the high-yield bonds, there could be a much higher risk of default that you might think. Rather than protect your portfolio when the economy weakens, these funds may actually book large losses if the companies default on the loans.
Notice that not only does the dividend fund pay a higher yield than the fund tracking the S&P 500, but it also does it with much lower risk.
While I have made the distinction between investments in MLPs, REITs and dividend stocks in the table, all three are an important part of a holistic dividend strategy. Combining the high yields and relatively low risk from all three asset classes can help smooth out market fluctuations and provide strong and stable income.
Dividend stocks can also offer protection against inflation. Sales and earnings both will tend to rise with inflation for most companies. Since dividend policies are often maintained as a percentage of earnings, the dividend payment tends to rise as well.
Besides the tendency for dividend payments to increase with inflation, there are several groups of dividend stocks that offer additional protection against rising prices. Utilities, the classic defensive dividend stocks, are often contractually allowed to raise the rate on their services by an inflation adjustment above and beyond an allowable rate of return. The adjustment may lag a year or two but will even out over many years and compensate for higher prices.
Other popular categories of dividend-paying companies exclusively invest in real assets. We’ll get into the specifics of companies that invest in real estate or energy infrastructure in a later chapter but suffice it to say that these hard-assets will tend to increase in value when the dollar losses its own value. The increase in asset value comes through as a persistent increase in the price of shares and adds to attractive dividend yields.
But isn’t inflation dead? Prices rose just 1.7% last year and have averaged just 2.1% over the last five. Before you shrug off the need to protect your assets against the loss of purchasing power, take a look at the graphic below.
Even at a low rate of 2.4% inflation, the value of your money halves in 30 years. Imagine getting to retirement and the value of your assets buys half as much as you were expecting. And low pricing pressure over the last decade may be the exception rather than the rule. In the 30 years to 2000, the average annual rate of inflation was 5.2%, more than double its current rate. Tack on historic programs of monetary stimulus by central banks all over the world and you’ve got a recipe for higher prices in the future. While we may not see the 7.1% rate of inflation experienced in the 70s, we are likely to see rates closer to 3% over the next several decades.
At a moderate 3% annual rise in prices, your dollar is worth just two-thirds of its value in 10 years and it takes just 23 years to halve its value.
Yield provides a safety net in market downturn
For me, all the data on dividends and market-beating returns is just icing on the cake. For many investors, these stocks are my ‘sleep-at-night investments.’ Academic studies and raw market data have shown that dividend-paying stocks are less sensitive to market changes and outperform the general market even more when stock prices come down.
Over the two decades to 2012, dividend-paying stocks within the S&P 500 posted an annualized return of 11.3% against 10.4% for stocks that paid no dividends. Again, icing on the cake but the dividend-payers also did it with lower risk and volatility in prices. The shares of dividend payers saw their prices fluctuate, as measured by a statistical term called beta, by just 92% of the market average. Shares of companies that paid no dividends saw their prices fluctuate 111% of the market average. Not only did the dividend-payers beat the non-paying stocks by nearly a percentage point on an annual basis, but they did it with much less risk.
Data from Standard & Poor’s for annual returns over the 85 years to 2012 shows that the average annual dividend return when the market is rising was 5% against price returns of 19% on average. During years when market prices fell, price returns averaged a negative 15% while dividends still provided a positive 3% return. When the market is rising, returns to dividend investing are good and adds to total returns. When the market is falling, returns to dividend investing are great and cushions you from wider losses.
Not only is dividend income always positive, but it can be relatively stable over time as well. Stock prices can fluctuate wildly on investor sentiment and stock bubbles. Dividend payments are a function of corporate financial planning, often years in advance, and much less subject to speculation. Over the three decades to 2012, stock prices swung by more than 15% on an annualized basis. In contrast, the standard deviation of dividend returns was just 0.47% over the period. Stock prices are the manic-depressives of the investing world, taking investors up to great heights before dropping them hundreds of feet straight down. Dividend returns are that slow, steady hike upwards until you reach the summit of your financial goals.
Running a company is a constant choice between growing the business and taking hard-earned profits. If profits are used to invest in more equipment and other business necessities, they could lead to more profits in the future. Profits paid out to the owners may not add to business growth but they are the ultimate reason for creating and running that business, to return profits to shareholders.
A dividend is those profits paid out to the owners of the business. While small companies may just have one or a few owners, very large companies raise money through selling shares and distributing the ownership over thousands of owners.
The decision to return profits or reinvest in the business isn’t necessarily an either/or decision. Most successful businesses make enough each year to return a little bit of profit as well as invest in future growth. Projects for growth are constantly evaluated for their potential return and how that compares to other ways to use the cash.
For most companies, dividends are paid quarterly according to a fixed amount for every share you own. There are companies that pay dividends twice or once a year, or even monthly but these are the exception rather than the rule.
Most dividend-paying companies pay a fairly constant dividend because they are interested in consistently returning profits to shareholders. For this reason, management often plans several quarters in advance to make sure they will have the money to pay for growth projects and a consistent or rising dividend. When they are sure they will have excess cash, they will raise the dividend. Conversely, the company may cut the dividend amount if management is unsure that the business will have sufficient cash. This is usually considered a bad sign for the company’s profitability and the stock price could decline considerably.
Besides regular cash dividends, a company may find itself with excess cash that it no longer needs. In this case, the Board might approve a ‘special’ or one-time dividend payment. The process of paying out this dividend is the same but it is usually much larger than the regular dividend payments and is extremely rare.
How the process of paying a dividend works
The Board of Directors is a group of people elected to represent you as an owner of the company. When management decides it will have sufficient cash for operations and growth projects, the Board of Directors votes to declare and pay a dividend. The entire process includes four important dates.
The declaration date is the day the dividend is announced by the company to the public. On this date, the company will also announce an ex-dividend date and payment date for the dividend.
The date of record is the date that determines which shareholders will actually receive the dividend.
The ex-dividend date is the first day that the stock trades without the dividend. This means, anyone that did not own the shares prior to this day will not receive the dividend payment. In a confusing twist, the ex-dividend date is usually before the date of record. This is because of the time it takes for share ownership to actually be recorded with the company, usually two business days. For example, if the date of record for a dividend payment in shares of McDonald’s (MCD) is on Friday, the ex-dividend date will likely be on Wednesday of that week. If you sold your shares on Wednesday, you would still receive the dividend payment because your sale would not be recorded with the company until after the date of record when it has determined who gets the payment.
The payment date is the day you will see the dividend appear in your account according to the amount and how many shares you own. For example, if you own 100 shares of the Coca-Cola Company (KO) and the company pays a $0.30 quarterly dividend then you will receive $30 on the payment date.
An important and usually overlooked difference in dividends is that of qualified versus non-qualified dividends. If you have not heard of this distinction, you’re not alone but it could save you a ton of money. Qualified dividends are taxed at the same rate as long-term capital gains, normally one of the lower tax rates you will pay. Non-qualified dividends are added to your regular income and taxed at rates up to almost 40% for those in the top tax bracket.
If you have a $150,000 portfolio, earning 4% in dividends each year and are in the top tax bracket, the difference between qualified and non-qualified dividends could mean an extra $1,500 in taxes and an extra $30,000 over 20 years!
The distinction is largely determined by when and how long you own the shares. The Internal Revenue Service (IRS) states that dividends can be qualified if you own the shares for at least 61 days during the 121-day period around the declaration date of the dividend. For example, if a dividend is declared on March 16th and you purchased the shares on March 5th, you must own them through May 14th for the payment to be determined as qualified. Basically, you need to own the shares for at least four months around the declaration date of the dividend.
The time qualification is the major distinction but companies must also declare dividends as qualified or not and foreign companies must be incorporated in the United States and be domiciled in a country with a tax treaty to be ‘qualified’ dividends. Most companies declare the majority of their dividends as qualified and many foreign dividend payments qualify as well.
This usually isn’t a problem for long-term investors that rarely sell their stocks. You may own the shares for years or decades rather than just a few months. Even when you go to sell shares, the fact that one dividend payment out of many is taxed as unqualified may not make a big difference. Increased taxes only start to bite if you are constantly buying and selling your dividend stocks.
Distributions versus Dividends
Another important distinction in the money you get back from your stocks is that of distributions versus dividends. Many people use the terms interchangeably but there is an important difference.
Dividends are a return of shareholder cash declared by a company. Distributions, most often paid by Real Estate Investment Trusts (REITs) and Limited Partnerships (LPs), are a return of equity in the company. A return of equity (or ownership) is returning part of the company to you the owner.
You pay taxes every year on dividends, whether at the capital gains rate or as income. The amount of distributions you collect are deducted from the original price you paid for the shares. When you sell the shares, you pay taxes on the difference between the sell price and the new, lower price you paid for the shares. Distributions may increase the taxes you own when you sell the shares but may not be due for many years depending on how long you hold the investment. Being able to pay taxes later on money made today is a great advantage of distributions.
I love market volatility! The VIX volatility index has surged more than 70% since late December to heights rarely seen over the last several years as slowing growth in China and interest rate fears threaten the six-year bull market.
As is always the case, in market fear is the opportunity for long-term returns. I’m not predicting a higher or lower market this year but, as a long-term investor, I don’t need to do so to be able to see opportunities.
Three groups top my list for best dividend opportunities of 2016 and produce four stocks with the potential to provide attractive yields and good long-term price appreciation. These three groups were among the hardest hit last year but have some of the strongest long-term fundamentals ahead of them.
Dividend Stocks to Feed the World
Strength in the U.S. dollar and record crop production in the northern hemisphere have brought prices for grains and other agricultural commodities to multi-year lows. The PowerShares DB Agriculture ETF (NYSE: DBA) lost 17% last year and trades for its lowest ever.
But cyclicality is the name of the game in agriculture and 2016 may be the beginning of a surge in crop prices. Producers in the southern hemisphere are already bracing for the La Nina weather phenomenon, which cools waters in the Pacific Ocean bringing flooding below the equator and droughts above it. Of the last 26 El Nino events, 40% have been followed by La Nina the very next year. The previous La Nina began in 2010 and ended in 2012, bringing a drought to the U.S. Midwest that sent corn prices to record highs.
The longer-term picture for crop prices is still better on the need for higher yields to feed the world’s growing population. Research shows that the global grain supply needs to double by 2050 to meet demand, an impossible feat that would require yield growth to double from its current trend.
I hold shares in several companies in the agricultural chemical space but two are particularly strong and among my top picks over the next few years.
Shares of Mosaic Company (NYSE: MOS) plunged 39% last year to an eight-year low as lower crop prices called into question the need for agricultural chemicals. The company is not only a leader in fertilizers but is vertically-integrated into mine supply as well, providing a stable source or raw materials. Even on lower prices, the company generated $1 billion in free cash flow last year and has $1.3 billion in balance sheet cash. Shares pay a healthy 4.4% yield and trade for just 7.4 times trailing earnings.
I highlighted Monsanto (NYSE: MON) in a November post on its leadership in the genetically-modified crop market. The biotech ag giant holds a #1 or #2 market share in its five largest markets and pays a 2.2% yield. Shares are higher since the November article but still a strong pick on long-term fundamentals.
The World will Always Need Energy
Another troubled market makes my list of best bets for 2016 and beyond. Oil prices have fallen further than anyone expected and OPEC has yet to blink in its price war with American producers. As with agriculture, the long-term upside is undeniable and current prices are a rare opportunity in an otherwise expensive stock market.
A Barclays survey found that capital investment in the energy industry was cut 20% last year and could come down another 8% in 2016, marking the first consecutive spending cuts since the mid-80s. The number of producing rigs in North America have been cut by 60% over the last year according to Baker Hughes. Oil and gas production will decrease in 2016 and it may be just as demand starts to outstrip supply.
In fact, BP is forecasting a deficit in oil production of 93 million tons annually by 2020 on strong consumption growth in Asia against sluggish production globally. We may not see $100 oil again for many years but one look at the chart for West Texas Intermediate (WTI) shows once-in-a-decade opportunity.
There could still be more fallout for the energy sector as bonds come due and energy prices struggle to recover. The SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) is diversified across 63 companies based in the United States. This gives investors needed risk reduction in the industry and the opportunity to wait out higher prices. The recent reversal of the oil export ban should give U.S. producers a competitive advantage against foreign producers when prices do rebound. Shares pay a 2.4% yield and trade for 17.1 times trailing earnings of the companies held, earnings which have come down significantly but should rebound in coming years.
Utilities Offer Upside as well as Safety and Yield
The markets have not been kind lately and I’m adding safety to my list of best dividend stocks for 2016. The utilities sector took a beating last year on fears of a rate hike by the Fed but are looking extremely attractive as investors rush for safety. The Utilities Select Sector SPDR ETF (XLU) was the third-worst performing sector last year after energy and materials but is doing well so far in 2016.
The sector fund pays an attractive yield of 3.7% but I like the higher 4.9% yield on shares of NRG Energy (NYSE: NRG) better. Shares of NRG have plunged under the weight of its alternative energy division but the company has recently split off the segment and is making other moves that will protect cash flow. The company is the largest U.S. independent power producer with assets in nuclear, gas, oil and coal as well as one of the largest retail energy providers. It is cash flow positive and has been aggressively buying back shares ahead of a rebound in the market.
Long-term investors have the benefit of taking the long-view and looking past weak markets in agriculture, energy and utilities. While there’s no guarantee that these three groups will rebound this year, the long-term demand picture is stronger and dividend yields offer plenty of incentive to wait.
• Strong commitment to shareholder cash return with 545 consecutive monthly dividends and more than 20 years of increasing payouts
• Rising interest rates and a long-term trend to online shopping may weigh on profits but the company is repositioning to protect growth
• Shares currently a discount of about 7% on five-year average valuation
Realty Income (NYSE: O) is one of the largest real estate investment trusts (REITs) with 4,400 properties. Most locations are freestanding, single-tenant and contracted on a triple-net lease where the tenant pays all expenses and maintenance. This reduces the management cost and risk around the property but also reduces rent yield.
Realty Income owns property in 49 states and Puerto Rico. Most states account for less than 5% of rental revenue though California (9.9%) and Texas (9.1%) together are nearly a fifth of revenue.
While the company has traditionally held retail properties, it has started to diversify over the last few years. This is in response to the trend from brick-and-mortar retail into the online space and should help protect sales growth in the future. While 80% of revenue comes from retail, many of the retail base is with large, established retailers that should be able to pay rents even as more shopping goes online. Nearly half (49%) of retail customers are from industries that are relatively protected from online shopping like convenience & drug, fitness centers, restaurants and dollar stores.
The company is slightly exposed to client-specific risks, as are most REITs. Two tenants account for more than 5% of revenue, Walgreens (7%) and FedEx (5.2%), and the top 10 tenants account for 38% of revenue. All the largest tenants are large companies with relatively stable financials but some risk remains. Investors can reduce this risk by investing in at least one other REIT focusing on different property types.
The big question mark lately has been the effect of rising rates on REITs. The special real estate holding companies pay out more than 90% of income each year in exchange for a pass on corporate income taxes. This means that new acquisitions and development must be funded with a continuous stream of debt and equity issues. Rising interest rates means debt becomes more expensive to issue and the company may need to issue more shares which are dilutive to current shareholders.
In fact, the market’s reaction to higher rates is clear looking at a chart of Realty Income (blue line) and the yield on the 10-year Treasury (red). Every time the rate on Treasuries went up over the last year, shares of Realty Income and other REITs took a hit.
But the argument breaks down over longer periods. Rates on the Treasury bond have fallen from 6% in 2000 while shares of Realty Income have returned an annualized 18.4% over the period. Rising interest rates normally coincide with positive economic growth and employment, both good factors for strength in shares of REITs. Market jitters over rising rates will weigh on REITs and Realty Income but it’s largely a temporary pressure.
Realty Income acquired 195 properties this year and has been able to lease them all with an average term of 17 years, well above the average lease term across all properties of 10 years. The company is able to manage an overall occupancy rate of 98.3% by offering attractive rents on long-term leases to large and stable retailers.
Realty Income Stock Fundamentals
Sales growth has slowed a little though deal spending has doubled to $1.2 billion a year and should support faster revenue growth over the next few years. The increase in investment spending has hit free cash flow growth but growth in operational cash flow is a better measure of overall growth.
The balance sheet of REITs is different from most other companies. Property accounts for almost all assets and the companies keep very little cash on-hand. Debt levels tend to be fairly high and maturities are short-term. REITs pay higher rates on debt so usually issue bonds at ten years or less. Realty Income finances half its capital structure with debt and has an average of $262 million in maturities over the next four years. This is manageable and the company shouldn’t run into any liquidity problems.
Realty Income Dividend and Growth
The dividend yield of 4.6% is just under the average of 4.9% over the last five years. To give you an idea of management’s commitment to cash return, Realty Income has trademarked the tagline, The Monthly Dividend Company.
Realty Income recently announced its 545th consecutive monthly dividend over 46 years of payouts. The dividend has increased 82 times since the company went public in 1994 and is one of the few REITs to pay dividends on a monthly basis. Dividends have increased an average of 6% annually over the last five years.
Realty Income Valuation
The traditional PE ratio means nothing for a REIT because it doesn’t account for the amount of depreciation that is taken each quarter. Instead, REIT investors use funds from operations (FFO) as a measure of income and value. FFO adds back depreciation expense and removes any one-time gains from the sale of property.
Realty Income is trading for approximately 17 times FFO, a discount of 7% on its five-year average of 18.3 times FFO. The company’s FFO per share grew at an annualized 9% to $2.58 per share over the four years to 2014. It’s not particularly cheap but isn’t expensive either and the dividend is well-covered. Of the 13% annualized return over the last decade, approximately 8.5% has been from price appreciation.
Realty Income is a great stock for smoothing your monthly income and the dividend is likely to grow steadily for years to come. Dual headwinds of higher interest rates and a gradual trend to online retail may mean that total return comes down slightly but investors should still be able to count on a return that matches or beats the general stock market.
This article marks the first of our Dividend Contenders series covering companies that have increased their dividend for 10 or more consecutive years but less than the 25 years needed to be Dividend Aristocrats. It’s a great list for finding up-and-coming companies that could one day graduate to the Aristocrats list.
Caterpillar Investment Highlights
Massive scale and its brand give Caterpillar survivability during the weakness in heavy machinery demand
Shares are trading at a 35% discount to the average trailing earnings multiple and a 13% discount to forward earnings
Strong buy on sustainable 4.3% yield and potential for high annualized return when industry demand returns
Caterpillar (NYSE: CAT) is the world’s largest mining and construction equipment manufacturer at $43.9 billion. In the construction segment, the company controls nearly a fifth (19%) of the global market and is twice the size of its nearest competitor.
More than a hundred years in operation, the company has a globally-recognized brand and sells equipment at a premium price compared to competitors. Marketing on quality and total cost of ownership has helped it sell in developed markets but has limited growth in emerging markets where purchase price is a big factor.
The company operates Caterpillar Financial Services to help customers finance equipment and sells through a global dealer network. Dealers are local in 131 countries and responsible for maintaining a service and repair network.
The company’s heavy equipment machinery is used primarily in three segments: construction, energy and mining.
The last year has been the proverbial ‘perfect storm’ for Caterpillar as all three segments have weakened. Slowing growth in China means less demand for global commodities and mining, as well as lower construction spending in the world’s second largest economy. Tumbling energy prices in the second half of 2014 are now showing through in reduced capital spending by companies in the sector, reducing demand for heavy machinery.
The entire industrial equipment sector is hurting and I won’t try to call a bottom in the stocks or the demand in the three segments.
But Caterpillar has one of the strongest brands and a low cost of manufacturing due to its scale and dealer network. The company is making the difficult decisions to protect cash flow and emerge stronger. Restructuring expenses are expected to shave $0.30 off of earnings this year but should help drive profitability next year.
Sales to North America could rebound relatively quickly on stabilized energy prices as production levels off heading into 2016. Sales to Europe also look marginally better next year on the region’s continued monetary stimulus.
The demand for heavy equipment is very cyclical and that means the cycle will pick back up eventually.
Caterpillar Stock Fundamentals
Caterpillar is half-way through its fiscal year so I have used adjusted fundamentals for the table below. Operating income has fallen slightly faster than sales because of fixed costs like administrative expenses. Operating costs should decrease significantly over the next several quarters on the restructuring program.
The company is highly indebted with 62% of the capital structure in long-term debt but shouldn’t face any liquidity problems. Caterpillar has more than $7.8 billion in cash, along with $28 billion in receivables and inventory.
Caterpillar has always been one of the more aggressive spenders on R&D and capital investment within the heavy machinery space. It’s helped the company maintain a wide lead in market share and a strong brand name. The company has cut its capital spending but still invested $3.3 billion in 2014.
Even on an aggressive capital spending plan, Caterpillar still generates nearly $4.0 billion in free cash flow a year. Cash flow is sufficient to continue growing the dividend payment, now at $1.7 billion a year, and to repurchase shares.
Caterpillar Dividend and Growth
Caterpillar prioritizes shareholder cash return and has increased its dividend even in the weak environment. The 4.3% yield is well above the five-year average of 2.6% on the drop in the share price. Against weaker sales and earnings, the payout ratio has increased to 49% from the five-year average of 35% of earnings.
In light of the tough picture for sales, I wouldn’t expect Caterpillar to grow its dividend significantly but it does look like it will be able to maintain a respectable growth rate. The company just increased its quarterly dividend by 10% in July and has grown payments by a compound annual rate of 11% over the last five years.
Dividends have increased for 22 consecutive years and have been paid since 1914.
Shares of Caterpillar trade for 11.7 times trailing earnings of $6.20 per share, well under the five year average multiple of 18.2 times earnings. The discount to the average trading multiple is consistent across the heavy machinery industry and a reflection of uncertainty on sales.
Sales are expected down 11.5% this year and 3% next year to $47.4 billion. Earnings are expected to continue falling to $4.57 per share next year, putting the shares at 15.9 times expected 2016 earnings.
Investors shouldn’t expect much in the way of price appreciation for a year or two but will earn a very good cash return until sales demand improves. When demand does come back to the industry, shares could bounce on higher investor sentiment and rebounding earnings. Shares have fallen to their lowest price in nearly five years and the company has the balance sheet and brand to survive.
Even if it takes five years for the shares to rebound to the 2014 high, investors will realize a 12.7% annualized return with the dividend. I do not expect the weakness to last that long and would recommend the shares as a strong buy.