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Are Larger Dividend Payouts Ahead?

Amid very low interest rates, stocks with healthy dividend yields will continue to be an attractive option to investors seeking income, says J.P. Morgan's Clare Hart.

Liana Madura, 11/28/2011

1. With the Federal Reserve signaling that rates will stay in the basement for at least two more years, how do you think investors can use equities as a source of yield and income?
With interest rates unlikely to rise anytime soon, stocks with healthy dividend yields will continue to be an attractive option to investors seeking income. Some large-cap stocks have dividend yields approaching or even exceeding the company's bond yield, effectively giving you an income stream similar to that of the bond with an equity kicker on top. For example, Merck MRK currently has a dividend yield of 4.57% and a 2011 free cash flow yield of 12.10%, while its debt only pays at a rate of 4.34%. Even though equities clearly have downside risk, the attractive free cash flow yields of many companies offer investors comfort that they are paying a reasonable price for those companies' future cash flows.

It is also important to remember that bonds are not without capital risk. Once interest rates eventually start to rise, many investors might find that bonds are not the safe haven they expected. In fact, in a moderate inflation environment, stocks often hold up much better than do bonds.

2. Has the continuing sovereign debt saga in Europe had a major impact on your holdings or strategy?
Our research process is designed to identify companies with predictable and durable business models deemed capable of paying consistent dividends while also achieving sustainable growth. Our philosophy emphasizes high-quality, lower-beta stocks that offer steady performance across a range of macroeconomic environments. Thus, we typically have a much longer holding period than many portfolios that employ shorter-term, more tactical strategies.

Europe's debt saga has not made a major impact to the holdings. In direct response to the crisis in Europe we have made adjustments to earnings where we think appropriate given a slowdown in European economies. Our approach to the strategy has not changed; we like high-quality companies that pay a healthy dividend.

We have also sought to minimize our exposure to global banks for fundamental reasons, though they could also be affected by the European debt crisis. Many of these banks fail to meet our dividend-yield requirement of 2% and are probably years away from normalized earnings levels. Instead, we have sought to focus our financial exposure on high-quality regional banks, investment managers, and insurance companies, many of which are trading at or below their book values. As a result, financials are the portfolio's biggest current underweight, a position that we arrived at through our bottom-up work but that we also feel very comfortable with on a macro level.

3. Many firms are sitting on big cash piles. What will convince boards to increase dividends during the next year? What is your outlook for growth during the next 12 months?
Given the severity of the financial crisis, it is probably not surprising that companies are hesitant to part with their cash piles. We have already seen a number of companies increasing their dividend payments. In fact, the number of S&P 500 companies that have increased dividends thus far in 2011 exceeds pre-financial-crisis levels. However, companies clearly have a lot more room to increase their dividends going forward. Payout ratios are still at historical lows (26% versus an average of 37% during the last 20 years) while cash on corporate balance sheets is exceptionally high. As companies gain confidence in the macroeconomic backdrop, and as we get more clarity around regulatory and tax changes, they will increase their dividends in greater numbers.

Of course, an exception to this will be the banking sector. Given the need that many of these companies have to meet increased capital requirements and regulatory oversight that dictates how they return capital to shareholders, it could be a long time before some of these companies are allowed to restore their dividends to normal levels.

4. What companies look attractive to you today on a total-return basis? Why?
We have found a lot of good buying opportunities in the investment management industry, for example T. Rowe Price TROW. T. Rowe Price has a dominant mutual fund franchise with above-average investment performance and inflows, resulting in a steadily increasing market share. Although T. Rowe Price is not subject to capital charges or Tier 1 ratios as other financials are, the firm often trades with the overall financials sector despite a business model that is not predicated on spread lending or availability of capital. The company also has an exceptionally strong balance sheet that allows it to weather market dislocations without raising equity or forcing massive layoffs. Its stock's valuation is near historically low levels, currently offering a 2.4% dividend yield.

Liana Madura is an assistant site editor with Morningstar.com
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