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Finding Sustainable and Growing Dividends Among U.S. Equity Funds

When it comes to a fund's long-term payout, quality and growth matter just as much as yield.

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Income-oriented equity investors have heard warnings ad nauseam about the dangers of chasing yield. They know they should broaden their purview, but high yields can be hard to resist, especially in the current low-rate environment. However, they shouldn't ignore such warnings because high yields don't always lead to the highest payouts over the long term. Putting other issues like total return and volatility aside for the moment, which factors have the greatest impact on a fund's future dividend stream?

The fact is that the sustainability and growth of a fund's payout can matter just as much over the long run as current yield. This is something that Morningstar's Josh Peters and others have pushed for years among equity investors. To illustrate this, let's revisit the 2007-09 credit crisis. Many companies cut their dividends during that recession, and the payouts for most funds fell. The big banks eliminated dividends entirely when their balance sheets exploded. Even some of the bluest of the blue chips, like  General Electric (GE) and  Pfizer (PFE), cut their dividends. There were few places to hide.

So, imagine that it's year-end 2007 and you're considering Cullen High Dividend Equity (CHDEX), which sported a healthy 3.4% 12-month yield versus just 1.8% for Vanguard Dividend Growth (VDIGX).

Unfortunately, Cullen's dividend peaked at $0.53 per share in 2007 before taking a dive. And it didn't fully recover until seven years later, when it hit $0.66. This would be a serious disruption for investors counting on that payout. Meanwhile, Vanguard Dividend Growth's dividend crested in 2009 at $0.292 per share. It did fall to $0.273 per share in 2010 but quickly rebounded in 2011 with a $0.313 payout. What's more, from 2008 to 2014 its payout grew 6.7% annualized while Cullen's grew just 3.4%.

So, while Vanguard Dividend Growth's dividend was more stable, its higher growth rate also meant that it did a better job of staying ahead of inflation. This is no small matter for retired investors. If the gap between the two funds' growth rates had stayed the same, Dividend Growth's dividend would eventually overtake Cullen's. Of course, the closer the initial yield between two funds, the less time it would take for the dividend of the higher-growth fund to overtake the other.

Quality Is the Common Denominator
The above example shows how a portfolio of quality companies with decent growth prospects tends to generate the most stable dividend stream. The funds whose dividends recovered fastest after the credit crisis tended to be those with higher-quality holdings, which also tend to emphasize dividend growth over current yield.

Such companies tend to be found in funds that focus on profitability, return on capital, and competitive advantages, as well as on dividend and balance sheet metrics. All else equal, companies with high returns on capital have higher dividend growth potential than those companies with low returns. This perhaps explains why funds that pursue dividend growth also tend to have higher-quality portfolios than those that pursue yield.

Take  Vanguard Dividend Appreciation (VDAIX) and  Vanguard High Dividend Yield (VHDYX). Dividend Appreciation tracks the Nasdaq US Dividend Achievers Select Index and is designed with sustainability in mind. It is limited to companies that have increased their regular dividend for at least 10 consecutive years. Vanguard High Dividend Yield tracks the FTSE High Dividend Yield Index, which naturally focuses on stocks with above-average yields, but excludes REITs and MLPs, two popular sources of yield.

Vanguard Dividend Appreciation, which recently had a 30-day SEC yield of 2.1%, has an average return on assets of 8.8%, versus 6.5% for Vanguard High Dividend Yield, which has a 3.2% 30-day SEC yield. Vanguard Dividend Appreciation's holdings also have a lower average debt/capital ratio of 37.6% versus 43.6% for Vanguard High Dividend Yield. So, Vanguard Dividend Appreciation’s holdings have both higher returns on capital and stronger balance sheets. Finally, 70% of Vanguard Dividend Appreciation's holdings have wide Morningstar Economic Moat Ratings, versus 56.5% for Vanguard High Dividend Yield.

Digging a little deeper into sustainability, the median payout ratio for Vanguard Dividend Appreciation's latest holdings was 37%. This means that just $0.37 of each dollar of earnings was paid out as dividends. This leaves these companies a comfortable cushion for paying dividends, even if their earnings were to fall. They also have the room to increase them. Vanguard High Dividend Yield, on the other hand, has a median payout ratio of 55%, leaving its companies with less flexibility.

Looking at the volatility of cash flows, only 10.4% of Vanguard Dividend Appreciation's portfolio is in companies to which Morningstar assigns high fair value uncertainty ratings. Vanguard High Dividend Yield has 17.7% of its portfolio in companies with high, very high, or (in one case) extreme fair value uncertainty.

Finally, sector weightings also give clues as to a fund's priorities. High-yield funds tend to favor traditional income sectors like utilities, telecom, and REITs. While these sectors usually offer healthy yields, their growth rates tend to be limited.  T. Rowe Price Dividend Growth (PRDGX), on the other hand, has just 1.8% of its portfolio in utilities and nothing in telecom firms. Meanwhile, it has healthy stakes in faster-growing consumer discretionary, health care, and technology companies.

To be sure, these sectors all have done well during the bull market and sport some of the market's highest price multiples. One should not necessarily associate high quality with low price risk. The share prices of these companies could still be as volatile, if not more so, than the overall market. You’re more likely to see stability, though, in their dividend payouts.

The above analysis is not an attempt to predict which particular funds will deliver the highest payouts over time. It's more to argue that the quality of a fund's portfolio affects the risks associated with its income stream and its potential growth. Usually, the higher a fund's current yield and the lower quality its portfolio, the greater the risk. A fund that balances current yield with quality holdings can provide a steadier payout and perhaps more growth.

Kevin McDevitt has a position in the following securities mentioned above: VDIGX. Find out about Morningstar’s editorial policies.