With interest rates at historic lows, bonds have become a difficult place to find income (although paradoxically, in 2012, asset flows into bond mutual funds have outpaced that of stock mutual funds yet again), so investors have looked to other assets for yield, most notably high dividend paying stocks. Stocks continue to be attractively valued relative to fixed income and cash. In addition, high dividend paying stocks offer investors the ability to grow the income to help offset inflation, whereas in bonds, the income is fixed. However, despite the attractiveness of stocks, and this ability to grow dividends, investors should not be distracted by a stock simply because it offers a high dividend yield. Instead, investors need to focus on a company's earnings growth, underlying business model, and valuation, in addition to its income stream.
Traditionally, Utility, Telecommunication, and Consumer Staples sectors have been defensive components of portfolios because cash flows from these businesses are generally stable. Therefore, in weaker economic times, investors typically look to overweight these sectors. Because of the relative consistency of the cash flow generated, these companies tend to pay out a sizeable portion of their earnings in the form of dividends. Stocks in these sectors (particularly utilities and telecom), have been an attractive place to satisfy investor's insatiable demand for yield, and as a result, has pushed up valuations within these sectors to unattractive levels. Not only do these companies have a higher dividend yield, but they also payout a very high portion of their earnings in the form of dividend. As of December, 31, 2012, based on a forward price-to-earnings multiple, the S&P 500 was trading at 12.5x. However, those companies within the S&P 500 that payout 70%+ of their earning were trading at 21x earnings, a 68% premium to the S&P 500! Companies paying out 35% of their earnings are trading at 14.5x, still a premium to the entire index, but demonstrably less.* If a company is paying out more than 70% of its earnings in the form of dividends, that leaves little from for dividend growth if the company's growth prospects decline. Investors also need to look at the amount of net debt (total cash - total debt) a dividend paying company has on its balance sheet. If net debt levels are high and the dividend payout is also high, and the company's growth prospects decline, then what may appear to be an attractive dividend, may be in jeopardy. Investors need to do research on each individual company they are investing in to understand the safety of the dividend, rather than simply buy shares of a stock because the yield is high.
In our Income with Growth strategy, we ask ourselves several very important questions before purchasing a high dividend paying stock, regardless if it is a REIT, MLP or common stock: What is the dividend yield? What is sustainability of that dividend? What is the growth rate of the dividend? What is the board's history of growing the dividend? What are the underlying earnings growth prospects of the company? Answering these fundamental questions is imperative to finding solid investments for income portfolios, rather than simply buying a stock because the dividend yield is high.
*Factset, Fidelity Investments (AART) as of 12/31/12; Fidelity q1 13 QMU report
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