Don't Ignore Yield Signs
We get a lot of questions about dividends. One of the most common begins with a false assumption: “I need to get a 4% yield. Why don’t you recommend a lot of stocks with very high dividend yields?”
Here are four key reasons:
First, insisting on a preconceived minimum dividend yield is unwise and unnecessary. If your portfolio’s dividends do not generate enough income, you can sell shares periodically to make up the difference.
Second, our research and that of others has shown that stocks with extremely high yields rarely deliver the best returns, even when you include dividends in the returns.
Third, the universe of high-yield stocks tends to be focused in just a few sectors. Fishing only in that pool of stocks can leave you with an unbalanced (read: risky) portfolio.
Fourth, companies that pay high dividends have less cash left to invest in their businesses, which limits their ability to grow profits and their flexibility to adapt to changes or weakness in the market.
All four are simple and direct arguments that reflect basic investment truths. And none of them seems to satisfy income-hungry investors. Well, we aim to satisfy, so let’s dive into the numbers and try to help subscribers have their cake and eat it, too.
Tthe highest-yielding stocks have not generated the strongest returns. Our research suggests that among dividend-paying stocks, in rolling 12-month periods since January 1990, stocks with yields of 2.8% to 4.5% have tended to generate the best returns.
Yields of 8%, 10%, and even 12% or higher are attainable — but history suggests you shouldn’t pursue them. Over time, the stocks with the highest yields tend to share the following characteristics:
• Subpar Quadrix® Overall, Momentum, Quality, and Financial Strength scores.
• High long-term debt as a percentage of total capital.
• High dividend payout ratios (dividends as a percentage of earnings).
• Low cash flow relative to net income or total debt.
None of these trends suggests investment appeal. So, we have two choices. First, we can sacrifice quality to chase yield. Second, we can sacrifice yield to chase quality. We go with the second option because quality stocks (such as those with high Overall scores) tend to outperform over time, and because you can synthesize income from a portfolio of such stocks. Rather than target the highest-yielding stocks, buy the best stocks — and be willing to sell periodically to generate income from the portfolio.
In the table below, we list eight stocks with yields of at least 2%. All offer solid fundamentals, superior total-return potential, and solid dividend-growth prospects. Three intriguing names are reviewed below.
Over the last five years, General Mills’ ($69; GIS) has grown its dividend at an annualized rate of 9%, supported by per-share profits rising at a 10% clip. The company pays out of 44% of profits in dividends, enough to keep investors happy while also giving the company plenty of flexibility to repurchase stock and expand its presence in emerging markets.
General Mills offers a diversified menu of food products. A stable of well-known brands of cereal, ice cream, yogurt, canned vegetables, and other food items targeted to consumers accounts for about 85% of sales. The cereal group gained market share in the August quarter on the strength of Cinnamon Toast Crunch, Chex, and Fiber One. Wall Street expects per-share earnings to climb 14% in fiscal 2010 ending May on 1% higher sales, and estimates are rising. With Quadrix Momentum and Overall scores of more than 85, General Mills is a Buy and a Long-Term Buy.
The recession will probably halt Johnson & Johnson’s ($64; JNJ) stretch of 76 straight years of sales growth this year. But the 47-year streak of dividend hikes should continue. Free cash flow is trending higher, and the company’s long-term debt load represents less than 60% of its cash assets.
J&J generates about 37% of revenue from pharmaceuticals, with another 38% from medical devices. The consumer-products group for which J&J is probably best known accounts for the remaining 25% of sales.
Wall Street anticipates a 2010 recovery for sales, projected to climb 5% and top 2008 levels. The market expects annualized profit growth of 7% over the next five years, and a combination of moderate revenue growth and aggressive cost controls could render that target conservative. The stock trades at 14 times trailing earnings, 14% below its five-year average. J&J, yielding 3.1%, is a Long-Term Buy.
Wal-Mart Stores ($54; WMT) has increased its dividend at a 15% annual rate over the last five years, a quicker clip than the growth of per-share earnings (9%). A modest payout ratio of 31% indicates that Wal-Mart retains plenty of cash to plow into growth initiatives.
The retail giant continues to push into emerging markets, such as China, and new technologies, including electronic medical records. The discounter’s reach extends even to the grave, with caskets and urns now available on its Web site.
While Wal-Mart believes it attracted a number of wealthier shoppers “trading down” to save money during the recession, the company now faces stiff competition to pry open the wallets of frugal consumers. Management forecasts flat same-store sales for the January quarter and is discounting everything from bananas to videogames during the holiday season. Wal-Mart Stores is a Long-Term Buy.
Death of the income stalwarts
Back in the 1970s and 1980s, many large, popular, high-quality companies paid yields that seem high by today’s standards. The S&P 500 Index’s income return ranged between 3% and 6% for most of the 20-year period and didn’t dip below 2.5% until 1996. Investors expected big, strong stocks to pay big, fat dividends.
In those days, many popular investment strategies centered around buying big blue chips — companies such as AT&T ($28; T), General Electric ($16; GE), and Pfizer ($18; PFE), known for their large dividends and financial sturdiness. Such strategies worked well in the 1980s and 1990s — large-company stocks outperformed small-company stocks during those decades. But after the huge market run-up of the late 1990s and the ensuing collapse of 2000, everything changed.
The collapse taught investors that many of the invincible companies were, in fact, mortal. In December 2000, AT&T cut its dividend 83%, the first payout reduction in more than 100 years of paying dividends. Earlier this year, in an effort to preserve cash, GE and Pfizer broke streaks of more than 26 consecutive years of dividend increases, cutting the payout 68% (GE) and 50% (Pfizer).
Seen from a distance, today’s market looks a lot like that of 20 years ago. But a dose of perspective suggests that the more things stay the same, the more they change. GE yielded 2.9% at the end of 1989, versus 2.5% today. Pfizer yielded 3.2% at the end of 1989, close to today’s 3.6% yield. But today’s GE and Pfizer are not the same. Their operating momentum is low, and their growth profile is hazy — they’re big, but they’re not necessarily blue chips anymore.
Plenty of large, well-known companies still offer dividend yields of more than 2.5%. But such yields are less common today than they were 20 years ago. And in many cases, they aren’t 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.