Dividends are like Rodney Dangerfield – they get no respect.  One reason is because stock investors are mainly interested in capital appreciation, not income, so they tend to overlook dividend yields.  Another reason is that dividend yields have historically been lower than bond yields, so they’re relatively less attractive to traditional fixed-income investors.  In reality, though, equity income can be a very important source of portfolio return, if the investment strategy is sound.

We believe there are three parts to a sound dividend investment strategy: a growing business, strong free cash flow support, and a culture of dividend growth.

Certain stocks offer high dividend yields, but if their businesses aren’t growing, their dividends aren’t likely to grow either.  Domestic electric utility companies offer one obvious example: the demand growth for electricity may only reach 1% to 2% per year.  We look for companies with mid-high single digit revenue growth rates, because these businesses can support dividend increases in future years.

Income-oriented investors are commonly attracted to high yields, though often times high yields are a fleeting feature.  A very high yield may indicate that the company is stretching cash flow in order to pay the dividend and may have to reduce it in the future.  One measure we use to determine whether a dividend is sustainable is the payout ratio: the percent of a company’s free cash flow (operating cash flow, less capital expenditures) consumed by the dividend.  If a stock offers a high yield, the company might be supporting it by paying out all of (or more than all, for a time) the cash it has generated during the year.  Companies simply cannot continue that pattern of spending beyond their means indefinitely.  For equity income stocks, we generally look for dividends to consume less than 70% of free cash flow.  This allows the company to retain some cash to invest in future growth opportunities.

With taxes on dividends rising, we recently saw numerous companies declare special dividends as a use of excess of cash on the balance sheet.  We’re not against special dividends, but we believe firmly that a management culture which is focused on balancing a significant regular dividend with investing in higher quality projects is better than one which pays out a big dividend only when idle cash is available.

How has this strategy worked?  We recently measured the dividend history of our 10 largest equity income (“dividend plus growth”) holdings against the S&P 500 to see.  Here’s what we found through 12/31/2012:

S & P 500 Peloton Equity Income
Average Yield     2.2%               3.6%
Average Dividend Growth – 5 Years     0.8%              10.0%
Average Dividend Growth – 10 Years     4.9%              11.5%

 

Far from stretched, we project that our top 10 equity income stocks will payout an average of just 55% of their 2013 free cash flow as dividends, thereby retaining the rest for future growth.  In 2009, when the S&P 500 dividend declined 20%, our largest stocks increased their dividends by an average of 7% – a show of financial stability and strength when markets were in severe turmoil.

There will always be important roles for bonds and cash in portfolios, as well as pure capital appreciation stock investments, and we love when our equity income stocks rise.  But when investors are looking for a growing stream of income – one which maintains their purchasing power over time – we think a sound equity income strategy focused on growing dividends deserves more respect than it typically gets.