Tap Into Pent-Up Dividend-Paying Potential

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. Has dividend growth become cheaper than current dividend yield? I am here with Morningstar DividendInvestor editor Josh Peters to take a look at this topic.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, if you think about the total return that you get from the dividend stock, you have the growth and the yield, does one of them look like it's cheaper to purchase today?

Peters: Well, it's funny. This is a relationship that kind of moves back and forth over time. I mean sometimes the market is very interested in growth, very excited about growth, willing to pay for very high rates of growth, projected way, way into the future, and stocks that don't appear to have a lot of growth will trade with very high dividend yields, even though they are, in fact, underpriced; they are capable of providing better long-term returns. That was certainly the case in the late 1990s, early 2000s. You could pick up a company like Realty Income that pays out almost all of its cash flow as dividends with yield in the 8%-9% area, and when that dividend did go on to grow in the mid-single digits, it turned out to be a terrific investment.

Now a stock like Realty Income is actually kind of expensive, trading a couple of bucks above our fair value estimate. Its yield is still high by the standards of the market at over 5%, but it's not the kind of compelling value relative to other types of opportunities to earn good total returns, yield and growth that are out there.

Glaser: So it seems like those companies now that could grow their dividend pretty aggressively over the next, let's say, three to five years, but they just aren't being priced as such right now?

Peters: I think so. I mean it's kind of that case where you say that the bird in hand is worth two in the bush. Well, sometimes you have to ask yourself, is the bird in the hand worth five in the bush or 10 in the bush? If there is a lot of pent-up dividend paying potential, sometimes it might pay to actually be a little bit patient, wait for a situation to play out, wait for dividend growth to really catch up to give you the kind of yield that you want. If you don't earn the big yield starting from day one, but over a couple of years, that can start to actually provide more total return, more value for your investment dollar than just having gone for that bird in the hand at the outset.

Glaser: Are there any specific sectors you think are prone to a lot of dividend growth in the future?

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Peters: I think probably when you look at the scale of dividend growth opportunities, I mean so much of it right now is in financial services. Think about how this sector has really operated from a dividend perspective historically. Banks would be fairly profitable, earning 15%, 20% type of ROEs, returns on equity. They can't reinvest all that capital, so they wind up kicking 40%, 50% of it out every year as dividends. Essentially it slows down the rate of the growth for the business, so that their whole business can pursue growth opportunities that make some sense, can actually earn those kinds of returns.

Well, here comes the crash, regulators clamp down, terrible things happening, a lot of banks going bust, other banks really needing to slash their dividends for lack of earnings and lack of capital. And then there is a company like Wells Fargo that has stayed quite profitable. I believe they've only had one quarterly loss through this whole period. And even now with their earnings still cyclically depressed because of high credit losses, they are earning at a very good level. They just haven't been able to pay out the kind of potential that they've had in the past. So there is lot of pent-up dividend paying potential on a stock like Wells Fargo.

Glaser: But how long are investors going to have to wait for the bank to become profitable enough to really get a meaningful yield again?

Peters: I think the bank is profitable enough right now actually. They made $0.55 a share just in the second quarter alone. Again, credit losses are still quite high. So this figure is actually somewhat spring-loaded; I think can grow quite a bit over the next couple of years as the economy recovers, loan losses start to come down. But if all you do is take 50% of that $0.55 a share, that's $1.10 a share on an annual basis. If you put that kind of dividend on Wells Fargo's current stock price, that's a yield of over 4% and would still have a fair amount of growth potential even off of that level.

So, even though right now the stock's yield is less than 1%, you wouldn't really think of it as something that you could buy in anticipation of a lot of income. It's got that kind of capacity, I think, and the question is always timing with these things; when are regulators going to relax? I think it's really going to be probably sometime next six to 12 months, 18 at the outside.

But banks like Wells Fargo that are so profitable even in this environment – U.S. Bank is another name with very similar dynamic – they are building up excess capital now so quickly, beyond what regulators are likely to require banks to hold even as capital standards go up. That money is going to have to start finding its way back to shareholders, and I think the management teams of these banks are determined to do that. They really want to restore that essentially broken relationship that they had with their shareholders after they were forced to cut their dividends.

Glaser: Josh, thanks for talking with me today.

Peters: Happy to be here.

Glaser: For Morningstar.com I am Jeremy Glaser.