Payout ratio tells a tale
It’s human nature to want it all.
As investors, we want dividends, we want profit growth, and we want our stocks to go up. At first glance, those goals may seem to be at cross-purposes, since the more a company pays out in dividends, the less it can afford to invest in its business to grow profits.
While investors cannot truly have everything, there are some stocks that seem capable of helping you obtain dividends, profit growth, and capital gains. To find such stocks, consider the payout ratio, or percentage of earnings paid out in dividends, from two different viewpoints:
1) Companies that plow cash back into the business have higher growth potential. Supporters of this theory may refer to the sustainable growth rate, which provides a rough estimate of profit-growth potential. To calculate the sustainable growth rate, multiply the earnings-retention ratio (the percentage of earnings not paid out in dividends) by the return on equity (income divided by stockholders equity).
To be sure, the sustainable growth rate is not a perfect measure. It assumes that every dollar of profits not paid out in dividends is reinvested in the company, and that those investments will generate a return on equity (ROE) in line with that of existing projects. Neither assumption is safe.
2) High-payout companies make better use of their money. A 2003 study by Robert Arnott and Clifford Asness found that after periods from 1946 through 2001 when the S&P 500 Index had a low payout ratio, it tended to deliver weaker 10-year profit growth than it did after periods with high payouts. The researchers cited two possible reasons for this trend.
First, companies hate to cut dividends, and a high payout ratio may suggest executives willing to pay generous dividends are more confident in their earnings outlooks. Second, companies with high payouts have less to invest, which could make them more picky about how they spend their money. Such companies presumably focus only on the most profitable projects, while companies with lots of cash may feel compelled to deploy that money on acquisitions or dubious projects.
While the arguments in favor of high-payout companies have merit, the study cited above does not tell the whole story. The market’s payout ratio tends to hit its highest level during earnings troughs, and it makes sense that profits would rise quickly during the recovery. Dow Theory Forecasts’ research, as presented in the chart below, suggests that S&P 1500 Index stocks with modest payout ratios delivered superior returns since 1994 — and currently earn higher Quadrix®scores.
With neither viewpoint on payout ratios completely correct, how should investors use the ratio as an investment tool? Try skimming off the best ideas from both camps. The table contains 22 dividend-paying stocks with low payout ratios, a history of solid profit growth, and high projected profit growth over the next five years. All also retain enough of their earnings to support substantial investment in their businesses, with sustainable-growth rates of at least 15%. Three such companies are reviewed below.
Johnson & Johnson ($66; NYSE: JNJ) has raised its dividend in each of the last 46 years, most recently an 11% hike in the June payment. J&J pays out 39% of its profits in dividends, providing a 2.8% yield. Over the last year, J&J generated more than $6.9 billion in free cash, giving the company plenty of latitude to invest in its business, acquire new companies, pay down debt, and repurchase shares.
The market expects relatively flat sales over the next 18 months as some of J&J’s drugs face new generic competition. But the company has prepared itself to maintain per-share-earnings growth. Restructuring actions should reduce costs, bolstering profit margins. J&J spent nearly $10 billion on share buybacks in the nine months ended March, and more repurchases are likely in coming quarters. J&J’s diversified business model also offers some insulation from economic trends. A substantial consumer-products business (24% of 2007 revenue) should see solid demand even during an economic slowdown, while the pharmaceutical and medical-device businesses follow their own cycles only marginally related to the economic cycle.
The drug business has run into trouble in recent quarters, hurt by increased generic competition and poor research productivity. But J&J should see pharmaceutical sales rebound on the strength of new drug launches over the next several years. The company has a strong product pipeline boasting roughly twice as many potential launches today as it had five years ago. Johnson & Johnson is a Buy and a Long-Term Buy.
Sigma-Aldrich ($54; NASDAQ: SIAL) has grown its dividend at an annualized rate of 19% over the last five years, while free cash flow rose at a 35% clip. With a modest payout ratio of 20% and steadily growing operating cash flow, Sigma enjoys the flexibility to pursue acquisitions as well as repurchase shares and extend its 32-year run of dividend increases.
The chemical maker’s international exposure and diverse array of more than 130,000 products targeted at various end markets should help it cope with a slowing U.S. economy. Overseas operations accounted for 63% of 2007 sales. While only 20% of Sigma’s sales come from outside the U.S. or Europe, the company expects faster-growing markets to generate a quarter of revenue by 2010.
Sigma enjoys competitive advantages that should provide an edge in a down economy. Demand should remain solid, as many of Sigma’s chemical products are nondiscretionary items for research scientists. Because of its large overseas presence, the company expects currency gains to add about 6% to sales in 2008. Sigma books costs in U.S. dollars but collects revenue in foreign currency. Since scientists worldwide tend to speak English, Sigma can concentrate its support services in the U.S. rather than opening costly facilities in many foreign markets. And 40% of Sigma’s research sales originate online — a low-cost fulfillment option operated out of the U.S. Sigma-Aldrich is a Long-Term Buy.
United Technologies ($62; NYSE: UTX) has increased its dividend at an annualized rate of 20% over the last five years. Still, a payout ratio of 27% leaves the company plenty of flexibility to reinvest its free cash, buy back shares, or further boost the dividend. United Technologies (UTC) repurchased more than $5 billion in shares in the year ended March.
The company appears to be dealing effectively with a slowdown in the U.S. economy. Consensus estimates project 14% per-share-earnings growth in 2008 and an 11% increase in 2009, and UTC’s sustainable-growth rate of 16% suggests those targets are manageable. Credit an international presence for those strong projections — more than 60% of revenue comes from outside the U.S. About one-fifth of sales come from high-growth emerging markets.
UTC has some exposure to weak U.S. construction markets. However, the company says it has not yet seen a slowdown in orders for its elevators or air-conditioning units. International operations represent a reason for optimism. The Otis unit expects to install 20% more elevators in China this year than it did in 2007. The company has been able to raise prices for its residential air conditioners in the U.S., helping offset higher fuel and raw-material costs.
While a slowdown in the commercial airline industry could affect UTC’s engine and helicopter businesses, the backlog in aircraft manufacturing remains strong. In addition, the company has high expectations for its new, fuel-efficient PW8000 turbofan engine. United Technologies is a Buy and a Long-Term Buy.