The Constancy of Dividends
March 21, 2013
by Bill Smead
of Smead Capital Management
Dear Fellow Investors:
The payout ratio on the S&P 500 Index currently hovers around 30% of the after-tax profits of companies in the index—at the low end of the last 100 years. In comparison, the capital appreciation portfolio here at Smead Capital Management has a payout ratio of 27%. This is important because most studies show that over 40% of the returns provided by common stocks come from dividends over long stretches of time. With those figures in mind, we reasoned that this is a good juncture to remind everyone about our vision of the next ten years as it pertains to dividends.
Howard Silverblatt of S&P pointed out in June of 2011 that the S&P 500 payout ratio averaged 52.3% since 1936. Additionally, he showed that the payout ratio from 1991-2011 was 46% on the S&P 500 Index, even though that was an era dominated by tech stocks, which paid little or no dividends. What will happen to dividends for the S&P 500 over the next ten years?
At Smead Capital Management we are making a few positive assumptions about the next ten years in the US economy that most stock-picking organizations aren’t making. First, we are assuming that China’s slowdown will cause commodity prices to decline, stimulating the US economy in the process. Second, we assume that 85 million echo-boomers with a current average age of 28 will be 38-years old on average in ten years. These are the years that folks get married, have kids, buy houses, and buy bigger automobiles. Third, we assume that housing is the most affordable in my lifetime looking both forward and backward. Lastly, putting all three of those together, we assume much better economic growth than most of our competitors and much better earnings growth.
If the S&P 500 companies grow their earnings at 6% per year for ten years and the payout ratio grows to 50%, dividends would be 6.6% in the eleventh year on today’s cost basis. Using a range of a 2% to 6% dividend yield on the S&P 500 Index, stocks could appreciate anywhere from 10% to 300% in the next ten years, with a median around 150%. Adding in the dividend payments during those years, you get a much less scary picture of participating in the stock market, if you buy in and stay put.
Now let’s look at our own portfolio of stocks. We use eight proprietary criteria for selecting stocks which include a number of qualitative aspects of a business which have been highly correlated to dividend growth. They include high free cash flows, strong balance sheets, a history of sustainably high profit margins, and wide moats. If our companies grow earnings at 8% (because of their qualitative superiority) and the payout ratio on them rises to 50%, our dividend the eleventh year would be 8.4% of today’s cost basis. At a range of a 2% to 6% dividend yield on our portfolio, you’d get a range of 40% to 400% appreciation over the next ten years. Include the dividend payments along the way and we believe we can approach long-term common stock investing with a great deal of confidence.
We thought you might like to see some evidence of this playing out in action. Eight of our companies have done a total of 9 dividend increases since January 1st of 2013. Here is that list of companies and their dividend increase so far this year:
· Amgen (AMGN) 31%
· Bristol Myers (BMY) 3%
· Comcast (CMCSK) 20%
· Home Depot (HD) 34%
· JP Morgan (JPM) 27%
· Nordstrom (JWN) 11%
· Pfizer (PFE) 9%
· Well Fargo (WFC) 36%
For an investor who started the year in our strategy, they have seen their dollar-weighted dividends raised by 22.45% on 31% of their portfolio. This has had the affect of raising the income by 6.96% in less than 90 days. Just like the owner of a rental property who is happy when rents rise, so are common stockholders as they watch those from the outside who are bidding the shares up to get at the income.
To summarize our opinion, we will state the following. Low dividend payout ratios leftover from a deep recession should get rectified by future confidence. The largest population group (echo boomers) will enter their most economically impactful years of life and restore confidence in the economy. Retired boomers hungry for income will pursue the companies which meet their need for income. Normalized dividend payout ratios will go a long way to removing the likelihood of disappointing long-term common stock ownership over the next ten years.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
© Smead Capital Management