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As Dividend Growth Slows, Focus Will Shift to Yield

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Josh Peters. He is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We're going to look at the prospect for dividend growth in the years to come.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Looking back over the last couple of years, dividend growth has actually looked pretty good. Do you think that this is a trend that can continue? What's your outlook for where dividends could go?

Peters: It's not going to keep up at this pace. We're coming off a series of years here now where the S&P 500 Index, as a whole, has had dividends growing at a double-digit rate. Some of that is recovery from the dividend cutting that took place from 2007-09. But the last couple of years, it's been dividends growing faster than earnings. Earnings growth has slowed down, especially in some sectors that do have some big dividends like energy. And historically, it's very unusual to have the kind of dividend growth that we've had for the market extend for more than just a couple of years. That's a trend that I think is going to change. I don't tend to think in terms of a one-year outlook, but when I think about the next five years, I think dividend growth is going to come down quite a bit for the market as a whole.

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Glaser: What will some of the swing factors be here, then? What's driven this faster dividend growth? Is it just a higher percentage of earnings is being paid out now?

Peters: Well, until the last year or so where earnings have stagnated, it had been a combination of still rapid earnings per share growth as well as some increase in the payout ratio. And just to frame that, payout ratio is an incredibly valuable statistic for analyzing individual stocks as well as patterns in the market overall. Payout ratio for the market, as a whole, historically had been 50% or 55% up until the mid-1990s. It dropped into the high 20s at one point after the crash. So, there has been some mean reversion to that--and that's helpful. But for dividend investors--for people who are looking for income--it's not real helpful if the company whose dividend has a yield of 0.5% triples its dividend, because now it's still only 1.5% and the market averages 2%. So, the payout ratio in that particular case has gone up a lot--it's a lot of dividend growth--but I look at it as remedial. It's probably a company that should have been paying a much larger dividend all along and still may not be paying a dividend that's useful to income investors.

So, the way I look at it is dividend growth has helped support the market overall, and the fact that higher-yielding stocks don't have that payout ratio tailwind so much--because they are already paying fairly generously--they haven't really participated in the benefit of that. When I start thinking about the next five years, I think the market attention might actually shift back more toward dividend yield as being the more powerful contributor to long-term total return. And you might think, "Well, interest rates are going up--you've got to be terrified of those higher-yielding stocks." But over very long periods of time, dividend yield is the dominant driver of real equity returns--that is, after-inflation equity returns. It's something that you can actually put in your pocket. What we see about growth is that abnormally fast growth slows, and I think that's going to put more of the emphasis back on yield to generate adequate total returns.

Glaser: What do you think that means, then, in terms of investment selection today? Should you be looking for higher-yielding names? Should you not be focused on growth at all, then?

Peters: I think, in part, that is a function of what you're trying to accomplish with your capital as an investor. One of the great things about dividends is that the question is usually about you--the shareholder--and less about the market overall. It doesn't mean that valuations don't matter or trends in big dividend-paying sectors like utilities or staples don't matter; but usually, if I want a strategy that's going to generate and compound my income and then eventually fund withdrawals in retirement, then dividends are a good place to start.

The best news for dividend-payers right now is actually we're coming out of a period of extended underperformance of high-yielding stocks, dating back not just over the last couple of years of pretty heady gains but over the last decade. That's very unusual historically. And for people who are worried about inflated valuations because interest rates have been so low, yes, there are pockets, like in any industry, where I think there are some stocks--maybe even some sectors--that are a little richly priced; but on the whole, you saw a big disconnect: Interest rates continued to go down and down and down after the crash period, but sectors like utilities, like REITs, like staples, their dividend yields held up. Investors were not discounting the idea that a 10-year Treasury was going to stay at 2% forever or that cash was going to yield one basis point forever. So, you've got a pretty good built-in cushion for interest rates to normalize and for these stocks to continue to produce pretty good total returns on an absolute basis.

What I worry more about, honestly, for the rest of the market is that you don't have the above-average yields and growth is going to slow; what if multiples also contract on top of that? You could be looking at some pretty poor total returns from just the market in general, which still has a low yield overall around 2%, over the next couple of years. I think one of the best ways to ensure that even if you don't get a great level of capital appreciation in your portfolio that you can still hope to meet your financial objectives and eventually fund those retirement withdrawals is to focus on the high-yield stocks that can pay and continue to grow those dividends from here.

Glaser: And you think utilities, REITs, and staples are probably the most fertile hunting grounds for those names?

Peters: Those are still the most fertile areas. You can look at energy, but you have to be careful--especially with the midstream names now. Look at the stability of those dividends, but that applies to any sector. Staples is one area of the market that I think is a little bit richly priced. With utilities, people are so terrified about the Federal Reserve raising interest rates that they have tossed stocks like Duke Energy (DUK) and American Electric Power (AEP) out with the bathwater. These are, I think, very attractive yields--very well supported--and can grow at mid-single-digit rates long term and provide you with a very worthwhile overall total return over a long period of time.

Glaser: So, dividend growth might be slowing, but there's no reason to panic for dividend investors?

Peters: Yes. I think it's more of a problem, honestly, for the rest of the market than it is for the high-yield stocks because if you've got a 4% yield, a 4% dividend-growth rate is pretty good; if you've got a 1% yielding stock, you need a ton of growth just to stay where you're at. So, I tend to think that you'd want to tilt more toward yield right now if you're a long-term investor with bills to pay and obligations to meet.

Glaser: Josh, thanks for the update.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.