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Dividends Not Just for Retirees

Mon, 10 Dec 2012

A strong and growing dividend can be a great signal of a quality stock for any kind of investor.

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Video Transcript

Jason Stipp: I am Jason Stipp for Morningstar.

Dividends have had a great tailwind recently as folks entering retirement are seeking income in a very difficult yield environment, but dividends aren't just for retirees or those seeking an income stream. A dividend can be a great signal of a quality stock for any kind of investor.

Here to talk about why is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: Glad to be here Jason.

Stipp: Dividends have gone through phases where they've been more popular, less popular. They're more popular right now. But why, just beyond its popularity or whether it's not popular, why is a dividend a good thing?

Glaser: Right now there are a lot of structural reasons for their popularity. You have really low yields in the fixed-income market, as people are looking at potentially common stocks in order to fill that income part of their portfolios, and you have a lot more folks retiring who need that income, who are looking for money to pay the bills.

But like you said, even beyond that, dividends can make a lot of sense for people. And I think that the first, and maybe most important one, is total return. Looking over the history of the S&P 500 over a long time, we think that about 40%--give or take a little bit depending on how you crunch the data--of that total return came from dividends and not just from the price appreciation. So, if you ignore dividends, if you only look at stocks that don't pay dividends because you think those are going to grow more or just don't care that much about it, you're leaving a lot of that total return on the table, and that's really what you're looking for as an investor. When you go to sell those stocks, when you go to really look at your portfolio when you need that money, that total return is what's going to get you there.

Stipp: On a fundamental level, dividends also say something very important about the earnings of a company.

Glaser: I think they absolutely do. When we look at stock investing, we've always advocated buying high-quality companies at a discount to their intrinsic value and holding them for a long time, so you can realize the value of that company. And dividends are a good signal that a company does have those potential competitive advantages and that there really are solid earnings and really solid cash flow behind what that business is doing.

If you didn't have that cash flow coming in the door, if it's just accounting profits or maybe a company that just sees sustained losses, they wouldn't be able to come up with that cash to pay out those regular payouts to investors. I think it is a good sign that the company is on a good track--not the only sign you want to look at--but certainly an important one. And particularly if you look at emerging markets, where you're more worried about governance, that dividend can be a sign that there really is good cash flow behind these names.

Stipp: If a company pays a regular dividend and grows that dividend over time, it also says something very important about the management of that company.

<TRANSCRIPT>

Glaser: Stewardship is incredibly important. When you buy a slice of a company, when you buy a stock, you're not just getting a piece of paper. It's not just some notional thing. You really are becoming an owner of the company. And when you're an owner, you want the people who you have tasked to run the company--the management--to be on your side and to really have your best interests at heart.

I think a company that has a good dividend policy, that wants to return that excess cash straight to shareholders instead of just letting it pile up on the balance sheet or using it to pad their pay packages, I think that is a really good sign that management is making decisions that are shareholder-friendly. So this could mean that they're less likely to make big, splashy acquisitions that might help build their resume, help make them think that they're empire builders, but do very little for the value of the company, do little for the value of your shares. Instead, they're worried about getting that cash back out to you, and I think that that's a good sign.

Now a company that doesn't pay dividends, that doesn't mean that management are crooks, that they're going to do something horrible. They might be focused on things like share buybacks. They might be in an early stage where they really need all of that money coming in to invest in the business, but certainly [a dividend can be] a good sign that stewardship is very strong.

Stipp: Some management teams and some investors may be reluctant to look at dividends, because they might see it as an admission that the company can't spend and reinvest all of this money that it's making. What's your view of that? Sometimes it's not a bad thing if a company can't [reinvest profitably] to get some of that money back as an investor, right?

Glaser: I think it's absolutely not true that just because a company pays out a dividend it means that they suddenly aren't going to be able to invest in the business and they're not going to be able to keep growing. And I think we've seen this a lot in the tech sector recently, where a lot of tech bellwethers have just been producing so much cash that they've realized that they need to pay some of that out as a dividend just because they're never going to be able to deploy all of that money.

And I think that's a good admission that the management team realizes that there are good opportunities out there, but not every opportunity is worth pursuing, not everything is worth throwing money at, and that sometimes the investors themselves might have better ideas of what they can do with the cash. It could be to use for income, it could be to reinvest in that very company, or to invest in other ideas that they have.

So, I think there is a good balance there, that you can find management teams and you can find businesses that produce more than enough cash to invest in all of the potential high-impact, high-return-on-invested-capital investments that you can make while still producing a nice income stream and letting the actual owners of the company--the investors--use that cash for what they think is best.

Stipp: A steady and growing dividend is certainly a good sign for a business in general. Let's talk about actually picking dividend stocks, because there are some pitfalls that you want to avoid.

[Morningstar DividendInvestor editor] Josh Peters has laid out something he calls The Dividend Drill. You're going to help us understand some of those points today. The first one is "safe dividend." We want the dividend to be able to be paid today, but also in the future.

Glaser: Josh really is the guru when it comes to dividend stocks, and I think that his method, the Dividend Drill, for investigating those stocks really is a great lens to look at investing in them.

The first one is thinking about, is that dividend going to be safe? As we saw through the financial crisis, dividends often are cut in times of stress, and avoiding those cuts can be a big part of dividend investing success.

Economic moats are probably the first thing you want to look at. Companies with narrow or wide economic moats have strong competitive advantages. They can keep competitors at bay, and … if the economy were to decline, certainly they're going to feel pain, but they're probably going to feel less pain than the companies that just don't have those sustainable advantages, and don't have those customer-switching costs and things like that. So, that's a good sign for them being able to continue to get the cash in the door to really keep their distribution the same.

Part of that is also looking at financial health. A company that has potentially a lot of debt, that could be running into problems with their creditors who are going to say, hey, you can't make those dividend payments anymore; you need to save that money for debt service. [Companies with] cash positions that maybe don't look so great. A company with good financial health is going to be much more likely to be able to maintain their dividend versus one in poor financial health.

Finally, the payout ratio: You can only realistically pay out so much of your earnings before you run into problems of not having enough money to invest in the business or worrying about a relatively small downturn meaning that you're going to have to cut that dividend. So, … the ideal payout ratio is going to differ between types of businesses and industries and other different factors. It's important to look at that ratio, and if you see it really creeping close to 100%, you know that you're in trouble and that a dividend cut could be coming.

Stipp: So, very important to have a safe dividend and a dividend that won't be cut, but it's also nice to have a dividend that will grow over time. How can you get a handle on that?

Glaser: It's more than just nice to have it grow. It's really crucial to that dividend investing. If the dividend just stays the same, you're basically buying a bond. It's basically fixed income, because you're getting that fixed payment. But the nice part about dividends is that, as inflation takes hold and as price levels rise, potentially the business will be able to raise their prices and also raise the dividend. So it helps your income stream keep track or keep in pace with potential price levels rising, which is a really important component there.

So to figure out if it's going to grow, you have to think, is the business itself going to grow? What are the prospects for cash flow growth over the coming years? Is this a mature industry where it's going to be relatively slow? Is it a business that for whatever reason is able to grow faster than that? Keeping that in mind is really going to be a key part of what can drive that dividend growth.

Another thing to think about is how much capital does that business need to get that growth? You can't grow without investment. And if it's a business that needs an incredible amount of cash to get that incremental growth, it might not be a good candidate for a big dividend or for a growing dividend, because that cash is really needed within the business. So, a more capital-light enterprise might have a better chance of improving that dividend and growing that dividend over time.

And the third piece is to think about will it grow as opposed to can it grow, because even if the business has the capacity to grow the dividend, management has to want to do it. So, if the management team says they really prefer share buybacks as a way to return that capital to shareholders or if they just seem not all that interested in giving out that dividend, no matter how good the financials look and no matter how big of a dividend they could support, if they're not willing to make that payment, you're not going to see it. So trying to figure out management willingness to pay the dividend is an important part.

Stipp: So, dividend safety and dividend growth, two key pillars here. The third one is your total return or how much you're going to get paid for investing in this stock, and that has to do with valuation and where you get in.

Glaser: Like everything, if you buy a stock that's incredibly expensive, your return is going to look worse than if you buy a stock that is incredibly cheap. And I know that seems somewhat simplistic, but if you buy even the best dividend-paying stock, and one that's going to grow consistently, but pay way too much for it at the beginning, you're not going to get a good total return. And like we said earlier, that total return is really what you're seeking, it's really what's going to make you hit your goals. So, making sure that you're getting it at a cheap price and that the initial yield looks pretty good, that you think it's going to grow over time, and that's going to give you that nice return that's going to help you reach your goals.

Stipp: So, lots of reasons why dividends can signify a great business, some tips on picking a good dividend stock. There is another thing, though, that we're dealing with right now, which is tax uncertainty.

Tax rates could go higher next year; we don't know yet. This is one of the fiscal cliff issues that Congress is grappling with. Will this put a headwind against dividend stocks, and investors should really stay away because of that uncertainty?

Glaser: Taxes are a big question for dividend stocks right now. There is no question about that.

As we talk about the fiscal cliff, something that gets talked about a little bit, but maybe not enough, is that one of the things that's going to expire is the equitable treatment between capital gains and dividends that was put in place in 2003 with the rest of the tax cuts. And that's looking like it very well could expire, and we could see the top marginal tax rate on dividends go up to close to 40%. And certainly, I think for some individuals in some cases, that will make those dividends less attractive, but overall the appeal of dividends we really think will endure even with these potential higher tax rates, and for a few reasons.

First off, it seems that there probably will be some kind of deal reached, and chances are that the marginal tax rates aren't going to change for all taxpayers. So, there will probably be a big chunk of people who are interested in dividend stocks who aren't in that top bracket, who aren't going to see their rates raised by quite that magnitude that you would at the very top of the marginal rate.

And also a lot of investors hold their dividends in accounts like 401(k)s and IRAs, and in other accounts that are tax-advantaged in a way that you don't really care that much about the tax rate because that's growing tax free for you.

So, I think those are really important points to keep in mind as we talk about dividends, and we talk about the fiscal cliff. In a lot of ways, dividends were very attractive before 2003. People were diving into those stocks. I think that the advantages that we've laid out before will still be there, diminished slightly possibly, but certainly the overall story remains the same.

Stipp: Even if you were very concerned about the tax rates and you wanted to try to sell your dividend stocks or not invest in dividend stocks, what else are you going to put your money in that has the same kind of traits as a dividend stock?

Glaser: I think that's the biggest problem, is that there just aren't that many great alternatives out there. So, you might think, OK, I am going to focus on capital gains instead. So, instead of looking for stocks that are going to give me a growing dividend, I am going to look for stocks that are either focusing on buybacks or are growing really quickly, because that way I'll get that capital gains rate, which will presumably be more attractive.

I think this is a case in which you'd be letting the taxes get in the way of a good investment decision or of a sound investment decision. Because if you rely on capital gains, that means when you need that income later, you're going to have to sell those shares, and that means you're at the mercy of what the market is trading at on any given day.

So, if there is a big correction, if there is a big sell-off, but those safe dividend-payers are able to keep that income payment, you're going to end up getting less than maybe the intrinsic value for those shares when you sell them to get the payout, while if you had stuck with dividend-payers, you would still have that income that still would be getting paid out to you. You'd be getting that check, and you could use it for whatever you wanted. So, [investing only for capital gains] puts you at the mercy of the market maybe a little bit more than you would want.

If you look at the fixed-income space, there aren't a lot of great options for yield there, as anyone who's looked at it recently probably knows, so dividend stocks really still are one of the best places to get that good total return picture with that income, even in a higher tax rate environment.

Stipp: Jeremy, you make a very strong case for dividend investing, not just for retirees. Thanks for joining me.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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