Dividends: A Timeless Component of Equity Return
By Richard Skaggs
April 18, 2012
With interest rates at historic lows and many dividend-paying stocks boasting yields comparable to or higher than US Treasurys, it is no wonder that dividends have recently been at the forefront of many investors’ minds. But dividends have a long history as a significant component of total return, and today’s buzz is just the most recent chapter. Stripping away the noise, what should investors consider as they survey the universe of dividendpaying companies? We believe dividend payments are poised to grow in 2012, likely faster than earningsper-share growth. The universe of dividend-paying companies is richer than it has been for some time, but companies can sport impressive dividend yields for a number of reasons, and this should give investors pause. Pursuing yield for the sake of yield can be a dangerous proposition, potentially leading to investments in weakening franchises. In our view, investors attracted to dividend-paying companies as a potential source of yield and total return must assess the value of the dividend relative to the strength of the company.
THE ROLE OF DIVIDENDS
Though dividends have garnered increased attention lately, their important role as a component of equity return is hardly new. With the bull market in the 1980s, many investors and corporate executives began to adopt a somewhat one-sided view that capital gains were the principal driver of equity returns. The challenging investment environment that has persisted since 2000 has prompted market participants to rethink this position, and with good reason.
Over the long term, dividends have been critical to total return. From the end of 1929 through March 2012, reinvested dividends provided almost half of the S&P 500 Index’s total return, or a 9.4% annualized return versus a 5.2% return for price appreciation alone. These results are striking in dollar terms. Hypothetically, a $100 investment made at the end of 1929 would have become $6,566 by the end of March 2012 based on price change alone. However, when adding the compounding effect of dividends, the same hypothetical $100 investment would have become $162,925. 1 The equity value is 24.8 times greater at the end of the period because of the yield component. Examining a more recent time frame, from the end of 1979 through the end of March 2012, the S&P 500 with reinvested dividends turned $100 into $3,145, compared to only $1,305 from price change alone. 1 Over the long term, dividends have a meaningful impact on total return.
STOCKS WITH A YIELD ADVANTAGE?
Today, nearly 40% of S&P 500 companies have dividend yields above the 10-year US Treasury bond yield. Since 1980, it has been rare for such a high percentage of S&P 500 companies to offer current yields that exceed the 10-year US Treasury yield. Stocks may potentially be a competitive source of income in this environment, and the prospect of dividend increases over time is an incremental advantage favoring equities versus the fixed coupons of Treasurys, although Treasurys do not have the same risk profile as equities.
If the business cycle continues in a constructive direction, we think dividend growth in 2012 could be strong enough to outperform growth in earnings per share. We believe S&P 500 operating-earnings-per-share growth may moderate in 2012 to the high single digits, compared to growth above 15% in 2011. Dividends have already begun a strong growth trajectory with a 16.2% increase in 2011, the fastest annual growth rate in 30 years. We expect that dividends will likely post growth rates in the mid-teens for 2012. Given the current financial strength of US companies, there is ample capacity to raise dividends above the rate of earnings growth this year. One of the reasons we expect strong dividend growth in 2012 is the S&P 500 dividend yield remains low by historical standards, even considering 2011’s lofty growth. The reasons for today’s low dividend yield provides insight into our dividend outlook.
CONTEXT FOR TODAY’S DIVIDEND YIELD
Low dividend payments today are the result of several factors, both historical and current. The S&P 500 dividend yield at the end of March was 1.9%; this compares to the 50-year average of 3.1% and the more recent 25-year average of 2.2%. Recall that dividend yield is equal to a stock’s dividend payment divided by price, so changes in either input can affect yield. Based on the chart below, when stock prices were very low during the Great Depression, the yield soared above 15%. Conversely, when stock prices were high during the equity bubble in 2000, the dividend yield bottomed around 1%. Recently, corporate earnings have increased, buoying stock prices. However, dividend payments have not risen as quickly as earnings, constraining dividend yields below historical averages.
Additionally, the trend of decreasing dividend payments that began in the 1980s has been slow to change. Today, in the wake of the 2008 financial crisis, managements have been cautious about boosting dividend payouts to levels commensurate with the increase in earnings power this business cycle. The chart below shows that dividend payout ratios have stayed relatively low since 2008. Rather than paying dividends and creating taxable income, many companies have reinvested earnings for business growth or repurchased shares as a secondary way to distribute cash to shareholders. Several tax-related roadblocks are lingering headwinds to higher dividend payments in the near term. Taxation of dividend income may change at the end of this year. Current law taxes most dividends at a favorable 15% rate, in line with the long-term capital gains rate. If the current tax treatment expires, dividends may be taxed as ordinary income beginning in 2013, suggesting a marginal tax rate up to twice that of capital gains. Additionally, many multinational corporations have substantial cash positions invested overseas, which would result in high corporate tax payments should the money be repatriated to the US to pay dividends. However, investor demand for dividends and the continued strengthening of the economic recovery are facilitating change in corporate dividend policies.
DIVIDENDS APPEAR POISED FOR GROWTH ACROSS SECTORS
The number of S&P 500 companies paying dividends has been increasing. Currently, 400 of the 500 companies pay a dividend, nearly 89% of the Index by market value. 2 This is in line with levels seen during the early 1980s when about 90% of stocks in the Index paid dividends, before capital appreciation became a primary focus. By contrast, during 2000 and 2001, the number of dividend payers fell to about 350 companies, since most technology companies did not pay dividends. During 2011, 301 of the 394 dividendpaying firms increased dividends, while the number of dividend cutters dwindled to fewer than ten.
Historically, dividend investors may have focused on specific sectors, like financials or utilities. However, we believe viewing the dividend opportunity through this narrow lens distorts the current picture. Lower dividends from the financial sector, for example, are masking dividend growth in other sectors. Financials, responsible for 29% of S&P 500 dividends near the market peak in 2007, led the most recent decline in S&P 500 dividends, falling from $8.07 in 2008 to $3.14 in 2011. Yet as the chart to the right indicates, a broader survey of the S&P 500 suggests a generally positive trend in dividend payments is reestablishing itself across sectors; dividends for the overall Index grew from $22.73 to $26.43 last year.
We believe it is possible to build a portfolio of stocks with strong current income potential that is also diversified across economic sectors. As seen in the chart at right, each of the ten S&P 500 sectors has a material number of stocks yielding 2%3 or more, and these aboveaverage dividend payers represent a fairly large percentage of each sector’s weight in the Index. For example, the consumer discretionary sector contains 80 companies, 32 of which pay dividends of 2.0% or higher. While the consumer discretionary sector has a total market capitalization weight of 10.8% within the S&P 500 Index, these high-dividend-paying companies constitute 44% of the sector’s weight in the Index. That is, nearly half of the sector weight is comprised of stocks yielding 2.0% or higher.
While an above-average dividend may be attractive to income-oriented investors, dividend growth over time can be more beneficial in generating long-term total return. For example, of the 32 higher-yielding stocks within the consumer discretionary sector, the median company had an annual dividend growth rate of 6% over the past five years. The consumer staples and healthcare sectors have been among the strongest dividend growers, at 9% and 10%, respectively. Companies in these sectors were less affected fundamentally by the severe recession of 2008 and continued to show healthy dividend progress. Dividend growth in the technology sector has also improved in recent years.
NAVIGATING THE UNIVERSE OF DIVIDEND-PAYING COMPANIES
With investors increasingly focused on yield, have dividend paying stocks become overvalued? There is no simple answer to this question because not all dividend-paying stocks are the same. Each company is different, as is its ability to continue to pay or increase its dividend. The universe of dividend-paying stocks is rich and varied, similar to the broad equity market, and needs to be approached with a rigorous and holistic investment approach.
Assessing a company’s ability to continue to pay and grow dividends is a central component of the Loomis Sayles equity research process. Our equity analysts examine a long list of fundamental factors to help determine a dividend outlook. In our view, the strength of a company’s business franchise and consistency of cash flows over time are two of the most important factors. Company managements generally do not want to be in a position of raising a dividend only to reduce it later. As such, companies are often conservative in setting payout ratios based on the long-term earnings power of the franchise. Other factors integral to a dividend analysis include company balance sheet leverage, merger and acquisition aspirations and, of course, the ability to generate free cash flow over and above that needed for business reinvestment. Smaller, highgrowth companies are generally less likely to pay substantial dividends, opting instead to reinvest capital into the company for future growth. More mature companies and those with high free cash flow are often good candidates for healthy dividend payouts.
The analytical challenge of high-dividend-paying companies is determining when the ability to grow a dividend has been curtailed. In our view, companies with strong business models offering competitive dividend yields and an increasing payout rate over time are among the most compelling equity investments. This offers the long-term investor an opportunity for strong investment returns from enduring franchises.
(c) Loomis Sayles