Even Aristocrats Feel The Strain
Dividend cuts have blindsided many investors this year, turning the search for income into a game of bobbing for apples.
Of the roughly 7,000 U.S.-traded stocks tracked by Standard and Poor’s, 113 decreased their dividend in the September quarter, the highest rate for the period since 1982. Total dividend payments for the stocks fell 44% year-over-year in the September quarter.
How can investors limit their likelihood of biting into a bad apple? Take a cue from history.
Consistent dividend growth generally indicates that a company is confident in its profit outlook. Shares of companies that regularly increase their dividends have outperformed over the long haul. The S&P 500 Dividend Aristocrats Index, which contains all S&P 500 components with at least 25 years of higher dividends, has outperformed the broader index by a wide margin since its inception in 1990.
The Dividend Aristocrats Index tends to generate better return on equity and higher-quality earnings than yield-driven portfolios. Perhaps most importantly to investors who fear dividend cuts, these aristocrats tend to deliver steady profit growth. High returns and strong earnings growth can support higher dividends even when times are tough.
Of course, even the strongest companies have not been completely immune to the extraordinary pressures seen since early 2008. At least nine of the 51 stocks in the index are likely to lose their aristocratic status next year because of dividend cuts made earlier this year. The average year-to-date return of these fallen aristocrats, 10%, lags the 14% average return of the other aristocrats.
The aristocrats as a group have lagged this year, as the broader S&P 500 Index has returned 20% and the median stock in the index has returned 22%. Money often pours into riskier stocks in the early stages of a rally. As the rally matures, stocks with stronger fundamentals tend to regain lost ground. For now, these high-quality stocks seem reasonably valued, averaging a trailing P/E ratio of 16, 9% below the average for all S&P 500 stocks.
Aflac ($42; AFL) has raised its dividend in 26 consecutive years. The insurer’s ability to grow the dividend depends on the health of its $71.6 billion investment portfolio, which has $3.1 billion in unrealized losses. Bonds rated below investment grade represented just 7.1% of the portfolio at the end of September. Sustained weakness in the credit markets could put pressure on Aflac, but the insurer currently generates more than enough cash flow to fund the payout. Over the last 12 months, Aflac paid dividends of $378 million, equal to less than 12% of cash flow from operations.
Despite a challenging U.S. business environment, Aflac’s operating earnings per share soared 21% on 11% higher sales in the first nine months of 2009, lifted by a strong yen. In constant currency, per-share profits rose 14%. Japanese operations have driven growth in recent quarters, sparked by sales through banks and a life-insurance policy that helps pay for children’s education. Aflac, yielding 2.7%, is a Buy and a Long-Term Buy.
Questar ($40; STR) has raised its dividend in each of the last 29 years, most recently hiking the quarterly payout 4% to $0.13 per share in late October. Questar’s stock has surged 23% so far in 2009 and no longer looks cheap based on trailing earnings, though it still trades more than 22% below its three-year average price/cash flow and price/book value ratios.
Natural-gas prices, depressed by the recession-related weakness in demand and a glut of newly discovered reserves, hit a seven-year low in early September. Natural gas represented 89% of Questar’s production volumes in the September quarter. Hedging activity helped the company realize an average price of $6.46 per thousand cubic feet, while natural-gas spot prices were below $4 per thousand cubic feet for most of the quarter. Questar has locked in 60% of expected 2010 production at an average of $5.26 per thousand cubic feet, 20% above the current price. Questar expects production growth of 13% to 17% in 2010. Questar is a Long-Term Buy.
Sigma-Aldrich ($53; SIAL), which sells ingredients used to manufacture specialty chemicals, boasts 33 consecutive years of dividend growth, including double-digit hikes in each of the last five years. Sigma-Aldrich has generated $274 million in free cash flow this year, up 17%. Cash assets of $292 million are nearly triple the amount of long-term debt. Strong financials have given Sigma the flexibility to repurchase shares, reducing the share count by nearly 7% in the past two years.
While Sigma is not immune to recessionary pressures, many of its products are crucial to clients’ research efforts. Sales fell 7% in the nine months ended September, but revenue rose 0.6% excluding currency effects, with all four business sectors managing modest growth. Wall Street anticipates per-share earnings will rise 6% in the December quarter and 13% in 2010. Those targets seem conservative, given Sigma’s strong market position and recent operating momentum. Sigma-Aldrich is a Long-Term Buy.