When high dividends equal low returns
A steady modest dividend yield is going to bring you better returns than a high one, says this U.S. advisory, and it has three buys to prove it.
How high is too high?
When the subject is profits, there is no “too high.” But when the subject is dividend yields, you’ve got a debate on your hands.
This is a debate we delved into not too long ago (see Daily Buy-Sell Adviser, November 30) when we heard from a leading U.S. advisory that urges investors not to chase dividend yield.
We return to the same topic today with another top Wall Street advisory, Dow Theory Forecasts. The advice is not substantially different — you do not need high dividend yields.
But this advisory has a fresh perspective on the way in which investing for income has changed in the past three decades. And it brings a fresh set of figures to the argument.
Not least, it offers three buy recommendations for stocks whose dividends are just where they ought to be.
No longer blue chips
Back in the 1970s and 1980s, says this advisory, many large, high-quality companies paid dividend yields that seem high by today’s standards. (The names included such stalwarts as AT&T, GE and Pfizer).
Buying big blue chip stocks was a popular strategy, and it worked. But after the large market run-up of the 1990s and the collapse of 2000, things changed. In December 2000, AT&T cut its dividend for the first time in more than 100 years — and cut it severely.
Now, blue chips like GE and Pfizer may still offer reasonably high yields, but the companies just aren’t quite the same. “Their operating momentum is low, and their growth profile is hazy — they’re big, but they’re not necessarily blue chips anymore.”
Even if they still offer reasonably high yields, they aren’t the companies you want to own. “Today, the most appealing companies — those with solid fundamentals, superior growth potential and reasonable valuations — rarely deliver the biggest dividends.”
Four reasons for less
You do not need a dividend yield of 4 per cent or more, this advisory states firmly. You can settle for less. There are four reasons for this.
First, insisting on a pre-set dividend yield is unwise. If your portfolio’s dividends aren’t generating enough income, you can sell some shares.
Second, studies show that stocks with extremely high yields rarely deliver the best returns — even when dividends are included in the returns.
Third, high-yield stocks tend to be concentrated in a few sectors, “which can leave you with an unbalanced (read: risky) portfolio.”
Fourth, companies that pay very high dividends have less cash left to invest in the business. This can not only limit profits but also deprive the firm of the means to adapt to changes or weaknesses in the market.
Two choices
Here are the measurements as compiled by Dow Theory Forecasts, which has made its mark measuring the market.
In rolling 12-month periods since January 1990, stocks with yields of 2.8 to 4.5 per cent have generated the best returns.
You can find stocks with yields of 8 to 10 to 12 per cent, “but history suggests you shouldn’t pursue them,” the advisory warns.
Their fundamental financial scores tend to be lower. As a group, they also have higher percentages of long-term debt compared to capital.
Their dividend payout ratios are high, that is, they eat up a larger portion of earnings. And their cash flow is lower in relation to net income or total debt.
“So we have two choices,” sums up the advisory. “First, we can sacrifice quality to chase yield. Second, we can sacrifice yield to chase quality.”
No contest, says the advisory. We’re going after quality. Here are three examples.
Keeping investors happy
The first stock is one that has put many boxes of cereal on many breakfast tables. General Mills (NYSE-GIS) has cultivated its dividend growth at an annual rate of 9 per cent.
That’s supported by per-share profit growth of 10 per cent, so the company pays out 44 per cent in dividends. That is “enough to keep investors happy while also giving the company plenty of flexibility to repurchase stock and expand its presence in emerging markets.”
Today, General Mills is trading at $69 and yielding a comfortable 2.7 per cent on its $1.88 dividend. It’s a Buy and Long-Term Buy (best buy for the next 24 months).
Another household name, Johnson & Johnson (NYSE-JNJ) has 76 straight years of sales growth. It should also continue 47 straight years of dividend hikes. Free cash flow is heading higher, and the long-term debt load is less than 60 per cent of assets.
Its sales are balanced — 37 per cent for pharmaceuticals, 38 per cent from medical devices and 25 from its well-known consumer products. The stock is trading at a modest 14 times trailing earnings.
The shares are at $64.61 and the yield is 3.02 per cent on the dividend of $1.98. It is a Long-Term Buy.
Wal-Mart Stores (NYSE-WMT) has been raising the dividend by at least 15 per cent annually over the past five years. With a modest payout ratio of 31 per cent, the chain can obviously afford to be generous.
This retail giant continues to expand into emerging markets like China, and into new technologies like electronic medical records. While it has attracted many wealthier shoppers “trading down,” the advisory says, it now needs to pry open the wallets of more frugal shoppers.
Wal-Mart is trading at $52.76 and yields 2 per cent on its dividend of $1.09. It is also a Long-Term Buy.
This advisory makes one more point. To generate income from your portfolio, you cannot rely solely on dividends. You must be willing to sell periodically.
So by all means go for dividends, but don’t let high yields lead you astray. In this race, slow and steady wins every time.
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