Dont live and die by dividends

5/12/2008


Once upon a time, dividends were more important than capital gains.

From 1926 through 1950, dividends accounted for more than half of the total returns of large-company stocks. However, dividend yields have declined over time, as companies gradually reduced the percentage of profits distributed as dividends. The charts below illustrate this trend. In the last decade, yields fell to unusually low levels, in part because stock repurchases gained popularity, and companies that wished to share the wealth with stockholders increasingly did it through buybacks rather than dividends.

Of course, dividends remain of crucial importance to investors, and not just to those dependent on income from their portfolios. Dividends provide a cash return even during periods when stock prices are declining. In addition, the market often views dividend-paying stocks as less risky, although many dividend stocks have performed abysmally over the past year.

In 2007, companies in the S&P 500 paid out more than $246 billion in dividends. The index’s per-share payout has risen at an annualized rate of 5.6% over the last 19 years, with gains in each of the last six calendar years. Yet over that period, the index’s dividend yield has declined substantially — to 2.1% at the end of March 2008 from 3.4% at the end of March 1989. Why the falling yield? Blame the index’s price.

Over the last 19 years, the S&P 500 Index’s price has outpaced dividend growth, rising at an annualized rate of 8.2%, driven by per-share-earnings growth of 7.4%.

With capital gains accounting for such a high percentage of stock returns, the Forecasts’ focus on total returns rather than just yield makes sense. That’s not to say we ignore dividends — we like dividend-paying stocks, but prefer to focus on companies that increase the payout regularly.

Good stocks with high yields are hard to find these days, a development that seems logical when you consider how the overall market yield has fallen. In January 1990, 28% of S&P 500 stocks yielded more than 4%. At the end of April 2008, just 13% of stocks in the index yielded more than 4%.

Investors seeking dividends should consider two questions:

How high is the payout ratio? Several high-profile dividend cuts in recent weeks are reminders that investors should consider whether companies they own can afford to pay their dividends. To calculate the payout ratio for stocks, we divided the indicated year-ahead dividend by estimated year-ahead earnings. For the most part, we prefer payout ratios below 60%, which suggest the companies have the financial flexibility to invest in their business and deal with downturns.

Do your stocks have sufficient profit-growth potential to support higher payouts? Every time a company raises the dividend, it not only boosts investors’ income, but also makes a statement about its own financial strength and confidence in the future.

Three stocks that have modest, sustainable payout ratios and seem likely to continue growing their dividends are reviewed in the following paragraphs.

Aflac ($67; NYSE: AFL) has grown its dividend at an annualized rate of 20% over the last 15 years. Supporting that payout has been annualized growth of more than 9% in sales and 17% in per-share profits. The insurer pays out less than a quarter of its profits in dividends, which provides plenty of flexibility for future increases.

Japan accounts for more than 70% of Aflac’s revenue, and new products and distribution outlets should drive double-digit profit growth in Japan over the next two to three years. By the end of April, at least 90 Japanese banks had agreed to sell Aflac insurance. By the middle of this year, Aflac expects to have signed up 150 bank partners in Japan. Bank channels accounted for just 1% of new sales in the March quarter. That proportion should rise rapidly. In October, Aflac will also begin selling through the Japanese post office’s 300 branches. These new outlets allow the company to expand its sales locations beyond worksites, where it has traditionally generated most new business.

A new cancer-insurance product also helped boost Japanese sales in the March quarter. With cancer the No. 1 cause of death in Japan and patients facing a higher deductible for the national health plan, the product is well-positioned in a growing market. Aflac is a Long-Term Buy.


Over the last 15 years, United Technologies ($75; NYSE: UTX) has grown cash flow per share at an annualized rate of 13%, comfortably supporting 12% dividend growth. In the last two years, UTC has returned more than 70% of free cash flow to shareholders as dividends or share repurchases. The combination of a modest 25% payout ratio and expected solid cash-flow growth over the next few years suggests more dividend hikes and buybacks are in store.

Results at the industrial conglomerate have held up well in the face of economic headwinds. The Carrier heating and air-conditioning division, which has exposure to U.S. residential construction, grew revenue 9% in the March quarter on solid international demand and currency gains. In addition, UTC has locked in copper and steel prices below market prices this year, giving it a competitive edge. The fire and security division saw a decline in U.S. residential revenue, but segment sales grew 28% in the quarter, driven mostly by currency benefits and acquisitions.

UTC has also positioned itself to benefit from long-term shifts in energy and environmental regulation. By reducing its carbon output while still increasing sales, UTC should have an advantage if the government levies a carbon tax. The company has set itself up as a provider of energy-efficient elevators and heating and air conditioning products. United Technologies is a Buy and a Long-Term Buy.


Despite delivering annualized per-share-profit growth of 12%, Wal-Mart Stores ($56; NYSE: WMT) shares have slumped this decade. The stock is down 18% since the end of 1999, though it has rallied 31% from January lows. The slumping economy sent many shoppers in search of the retailer’s low prices. Wal-Mart has delivered modest sales growth in recent months, which looks good relative to the results of many other retailers.

Wal-Mart has raised its dividend every year since initiating the payout in 1974. Over the last 15 years, the dividend rose at a 20% annualized rate. The company is working to boost cash flow, which would provide more room for further increases. Wal-Mart has set five goals for increasing its cash flow, meeting four of those goals in the six months ended January.

In this slow economic environment, Wal-Mart sets itself apart from other retailers. In the January quarter, the retailer delivered higher same-store sales growth than its leading competitor in five of the six segments Wal-Mart uses to divide its sales. The discount retailer also has plans to grab a piece of consumers’ federal tax rebates. Wal-Mart has lowered prices and plans to cash stimulus checks free of charge, hopefully encouraging customers to spend those checks in the store. Wal-Mart is a Long-Term Buy.


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