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Dividend Growth Dwindles as Earnings Growth Slows

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Josh Peters. He is the editor of our DividendInvestor newsletter. We'll look at the future of the dividend growth and if we are seeing a slowdown.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: We've talked in the past about how dividend growth almost has to slow down because earnings aren't growing very quickly. Are we really starting to see some evidence of that?

Peters: Yeah, that slowdown in dividend growth is really starting to bite. I did some statistical research here recently just looking at trends in dividend growth over different time periods. And you go back to 2003, from 2003 to 2015, you can almost say that was a golden era for dividend growth now historically. It started in 2003 when Microsoft, the pre-eminent tech name then, comes out and declares its first-ever dividend. There were some other tech companies like Intel that had paid before, but that was a real landmark event. That's when the tax treatment was equalized with long-term capital gains and you started seeing a big ramp up in dividend growth.

Most of the time, in that 12-year period, year-over-year dividend growth was in the double digits. It was, of course, 2008-2009, where it was double digits with a negative sign in front. But I think a lot of people got this idea that dividends are just naturally growing double digits except for those higher-yielding names that only raise their dividends, you know, maybe 4%, 5%, 6% or something like that. So dividend growth becomes this very popular theme.

Well, year-over-year in the first quarter, according to Standard & Poor's dividend growth for the index slipped to less than 5% on a year-over-year basis and this continues a trend of slowing growth that had been in place for a couple of quarters and it's finally starting to reflect the fact that earnings are not growing at all. Earnings are dropping and with that we've had a very interesting cross in the data that in the trailing 12 months through the first quarter of 2016, the payout ratio of the market on GAAP earnings--Generally Accepted Accounting Principles earnings--for the Index is at 50%. That's first time it's been historically normal outside of a recession-type of periods since the mid- to early 90s.

Glaser: If there are signs that we've reached the end of this fast-growing dividend growth, is there still opportunity for kind of that mid-single-digit growth to continue or now they were at 50%, do you think it could fall or we could even see some dividend cuts coming?

Peters: Well, we have seen some dividend cuts. One of the interesting things is, Kinder Morgan's dividend cut late last year, I mean that alone is almost a percentage point drag on dividend growth for the whole market. That's just how big a payer they were and how deeply they cut by three-quarters to their dividend. So energy sector dividend cuts have had a factor influence there. But it's also a lot of the bigger companies that, frankly, had gotten on board with the idea that they needed to pay more and now they're starting to feel a little bit tapped out.

So I use Procter & Gamble as an example, stock I own, I've been real happy with it, but I'm still being patient with their turnaround progress. But like the market overall, they have been raising their dividend pretty aggressively for years and earnings have stagnated. And so now you're at this point where the payout ratio has been pushed up to a level where they can really only afford to continue raising the dividend meaningfully if they're getting that earnings growth. And I think for P&G, whose payout ratio now is over 70%, it's a stable enough business, generates a lot of cash, they can continue to afford that. But for the market overall, that's more cyclical. I think payout ratio in the 50% area does put the brakes on this very rapid period of dividend growth that we've had.

Glaser: What's the takeaway for investors then? Is it that you should look for more yield upfront? Is it you should not think about growth as much? What would your suggestion be?

Peters: I think as more people notice, and a lot of people have already noticed this. But as more people notice the dividend growth is slowing down then it will be another opportunity for the haters to say, oh, dividends are not working anymore, we need to get out of this dividend trade or something like that. And I draw the opposite conclusion, which is the less dividend growth is out there and the less earnings growth that's out there, the more important that big dividend yield becomes as a component of your long-term total return.

If you're the average investor with the market average portfolio that yields around 2%, then that's all you can count on in terms of income. So if the growth kicks out of the equation, then you're really looking at a pretty poor return. The portfolio I manage is targeting a 4% yield. We're a little bit below that today because valuations are a little bit on the high side, but still we're starting out with a huge advantage relative to the market and it's being paid in cash. So I don't assume by any means that I should be expecting or the market should be expecting double-digit growth to return anytime soon.

I mean historically normal's probably maybe like 5% give or take, not 10, not 15. So if in that paradigm, if everybody is going to kind of be drawing from this pool of 5 percentage type of growth, then why not try to get it with stocks that yield 4% instead of 2%. If you can do that and manage your risk at the same time, then that might be the best way to earn good returns even as growth slows.

Glaser: Josh, as always thanks for joining me.

Peters: Thank you too, Jeremy.

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