The Predictable Returns of Dividends

Despite the low returns, I can see why some investors like bonds. They're a lot less work. Bonds spell out the exact terms of future cash payments. As long as the issuer is solvent, the yield you see (if you hold to maturity) is the return you get. All the potential buyer needs to judge is creditworthiness (Is it safe?) and the attractiveness of the yield (What's the return?).

Common stocks have no such contractual terms. Moreover, with current dividend yields far lower what most of us would consider an acceptable long-term total return, most of the value of the average stock is contained in future, uncertain dividend increases (Can it grow?).

Can we find almost bond-like consistency from stocks? Some of the 1,700-plus stocks Morningstar covers are far more predictable than others. Narrowing our field to these blue chips is a low-stress strategy that can still offer attractive, even market-beating returns.

Buy-to-Sell Versus Buy-to-Hold
Your average amateur stock-pickers--and an overwhelming number of professionals--think in terms of buy low, sell high. Sounds simple enough, but this is quite difficult in practice. For starters, have you ever pondered what "low" means? Is it buying companies in trouble, whose depressed share prices could rebound when challenges abate? Or does it mean looking for catalysts--change factors that will lead to materially higher earnings that the market doesn't yet appreciate? Either way, the investor is forced to speculate on a change in current earnings, cash generation, or even news flow.

Worse yet, what is "high"? I'm no great fan of selling stocks--even at a gain--since it poses not one but two significant problems. A "high" sale implies that the price discounts any and all future gains in dividend-paying ability, leaving only an inferior future return. (Again, we find ourselves speculating on the future.) And having sold one investment, we're obliged to replace that stream of total returns with one at least as attractive--and after paying transaction costs and taxes, we have less capital to put at work.

I'm not afraid to sell when the underlying economics of a business are deteriorating, or when we might find a truly compelling opportunity. In the Dividend Portfolio I manage in our DividendInvestor newsletter, I've earmarked two stocks for sale on this basis. But the hurdle for such moves is necessarily high.

What I'm really after are annuitylike streams of predictable, growing income that I can hold indefinitely. Warren Buffett describes his preferred holding period as forever. My term, indefinite, simply means that I don't care to buy stocks with a purpose to sell them later. To benefit from dividends and dividend growth, you've got to participate--and that takes time.

In Praise of Consistency
Just consider the benefits of a consistent stream of dividend increases:

More-predictable returns. Over long stretches of time, the return from a stock will tend to correlate to the initial dividend yield plus subsequent dividend growth. In any given year, many other factors--swings in earnings, stock market fads, economic booms and busts--can overwhelm this formula. Over a lengthy time horizon (three to five years or more) these cyclical variations start to get smoothed out. But we can also increase the predictability of our returns by seeking consistent dividend-raisers. The more predictable a dividend seems, the more likely our returns will stay in a range that reflects that.

Less volatility. Hedge funds and other hot-money investors overwhelmingly prefer volatility, since it gives them plenty of opportunities to buy low and sell high. But when the bulk of a stock's total return is built with steady dividends, there's less reason for investors to obsess about quarterly earnings estimates, management soap operas, merger rumors, and the like. The company acquires a long-term, low-turnover base of owners who have reasonable expectations--and little reason to dump at every short-term bump in the road.

Easily appraised management 'will.' Projecting dividends--as opposed to earnings--adds the question of where the cash will go, rather than just how much there will be. A steady record signals that management will indeed share earnings growth through dividends.

Enforcement. This is probably my favorite side effect of a long, lustrous dividend record. Having attracted owners that expect regular, consistent payouts, management dares not risk alienating these holders with a halt in growth, much less a dividend cut. The best dividend-growers thus manage their enterprises in a way that supports sustainable dividend expansion--a conservative balance sheet, efficient generation of cash, a focus on core operations, and appropriate investment for growth in earnings and dividends.

In Search of Consistency
When you've got a consistent record--such as with Dividend Portfolio holdings  Johnson & Johnson (JNJ) and  Coca-Cola (KO)--the question shifts from "What will growth be?" to the much simpler "Can it continue?" It's easier to confirm an admirable record than it is to speculate on the future. Moreover, the all-important will to raise the dividend (as opposed to the theoretical way) is much clearer.

But while achievement gets us started, the record alone isn't enough.  Fulton Financial (FULT), for example, stands out with arguably the most consistent dividend record in Morningstar's coverage. Since 1995, it has raised its annual payout by an average of 10.4%--never more than 11.6%, never less than 9.1%. But Fulton hasn't achieved this with earnings alone, which have risen at only a 6.5% annual clip. Instead, the payout ratio has crept from 38% to 54%. At a 54% payout and a 13% return on equity, future increases should fall to about 6%.

Fulton may go on raising the dividend faster than earnings for a while longer--sending the payout ratio higher and higher--but unless ROE improves, doing so only erodes growth potential while possibly placing the payment itself at risk.

The best achievers for investment are those with sustainable financial metrics--the kind our Dividend Drill used in DividendInvestor easily reveals--and those that have indicated total returns within our 10%-12% target range.

What's It Worth?
One question remains: Is the implied total return (current yield plus our growth estimate) enough to make the investment worthwhile? Take  Consolidated Edison (ED), whose dividend has risen in each year for three decades now. That's nice to know, but in the last 10 years, that dividend has grown at a piddling 1.2% per annum. Over this same stretch the consumer price index has climbed at a 2.5% annual clip, more than twice as fast. The $2.04 dividend Con Ed was paying in early 1996 was actually worth more than the $2.30 it's paying now, adjusted for inflation. With a 1.2% growth rate and a yield of 5.3%, our prospective total return doesn't stand to be much more than 6.5%. I'd much rather go with a stock like  Sysco (SYY), whose yield (2.2%) is less than half of Con Ed's, but whose dividend is rising some 10 times faster.

And we shouldn't limit ourselves to past achievers only. There are plenty of meritorious stocks that haven't paid dividends for a full 10 years yet; others--like  TC Pipelines --may be in a temporary payout-growth lull. Yet with all stocks, no matter how long or short, good or bad their records, we want to be forward-looking in our analyses. If we correctly pick future achievers, then all the benefits of a consistent, lengthening record will accrue to us as shareholders.