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Seeking Sound Dividends: Growth, Moats, and Yields

October 20, 2012
Seeking Sound Dividends: Growth, Moats, and Yields

Investors are in a jam. Back-to-back market crashes seem to have taught baby boomers that they can’t rely solely on capital gains to fund their retirements anymore, and record-low interest rates have stemmed the once-steady cash flow from bonds.

“If you want the potential inflation hedge, the income, and some chance of capital appreciation over the long run, there is just one door open – high-yield equities,” said Josh Peters, founding editor of Morningstar Inc.’s Dividend Investor Newsletter.

Of course, dividend investing isn’t exactly new. It’s been around as long as, well, dividends, and some Blue Chips have payment histories stretching back more than a century. What is new is that investors of all stripes are looking into dividends, which were once written off as too boring for anyone but well-heeled retirees. Compared to most of the alternatives out there today, though, those yields of 3% or so look downright growth-y, say some proponents.

The Dividend Advantage?

The potential advantages of buying dividend-paying stocks are obvious, said Sam Stovall, chief equity analyst for S&P Capital IQ. “Since 1926, about 40% of the S&P 500 Index’s total return has come from reinvested dividends. Getting a 40% premium on your money just for letting it ride is hard to beat,” Stovall said. That yield provides a nice payment every quarter, but in the event of a hard market fall, dividend paying stocks will get whacked just like the rest of the market.

Another plus, particularly during shaky equity markets, is that dividend-paying companies tend to have large market capitalizations and may have more stable business operations, which means that their profits might not be as vulnerable to economic downturns. As a result, their stocks may be less volatile than the market in general, Stovall said.

Screen Test

Use the TD Ameritrade Screeners tool to determine a potential stock’s divided yield, dividend frequency, and more.  
When creating a customized stock Screener, select Dividends as one of your criteria. You can set alerts on ex-dividend and payable dates.

Take a Closer Look

Many popular dividend strategies, such as The Dogs of the Dow, focus on finding the highest yielding stocks within a certain group or sector. But not all yields are created equal, Peters warned. Investors need to look behind that number to decide its true value. First, of course, there is the standard due diligence. Dividends are paid out of net income, so does the company have a long history of growing its earnings? What about its balance sheet? It is carrying a lot of debt?

“If earnings drop all those creditors need to be paid before a dividend can be paid,” Peters says. “That’s what happened to the banks in 2008 and 2009.” Many top financial services companies had to cut dividends during the global financial crisis.

Focus on Growth

Then investors need to gauge management’s commitment to maintaining and growing that dividend. Does the company have a long track record of paying dividends, and how often has it raised its dividend over the years? This analysis is critical because the real strength in dividends is their ability to grow, Peters said.

Say a stock is yielding 4% today. If the company has consistently raised its dividend 10% a year, in seven years the income from that investment could double – on top of any potential capital appreciation. “That dividend becomes more valuable than one that doesn’t grow,” Peters said. Of course, dividends are declared by the company’s board of directors, and even a very long dividend history can change at any quarter.

Build a Moat

Finally, “look for companies, with economic moats – a competitive advantage that will last over time,” Peters said.

For example, say you are comparing two companies: One owns natural gas pipelines and the other is an apparel retailer. The retailer can post huge profits when it hits the fashion trend just right, but fashions move quickly. If the company is depending on those profits to sustain a dividend, investors could be in trouble when skirt lengths change. Pipeline companies, on the other hand, enjoy high barriers to entry, such as extensive up-front costs and regulatory oversight. “They generate lots of cash and enjoy a competitive advantage that can last for decades,” Peters said.

Don’t Necessarily Yield to Yield

Investors can also tell a lot about a company by its yield alone, S&P’s Stovall said. That’s because like bonds, a stock’s yield moves in the opposite direction of its price. Too high – anything over, say, 6% – and there is probably a good reason why the stock has dropped and the yield has risen, said Stovall.

Too low and investors have probably piled on the stock already, driving its price up beyond its current market value. It would take a drop in the stock price or a big jump in the dividend to get back into what Stovall considers a reasonable range – between 3% and 6%.

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