By Greggory Warren | Senior Stock Analyst
Domestic equity markets, as represented by the S&P 500 TR Index, are up nearly 10% since the start of the year, and Morningstar's universe of stock coverage is collectively trading above the fair value estimates derived by our cadre of stock analysts. Thus we expect dividend-paying stocks, which had fallen out of favor in the back half of 2012 (as investors fretted over potential tax increases) to once again work their way on to some investors' radar. Although we've seen increased interest in equities this year, with close to $35 billion flowing into actively managed stock funds since the start of 2013, according to data provided by Morningstar DirectSM, most of the capital has been dedicated to international stock funds (primarily those dedicated to diversified emerging markets and foreign large cap stocks), which tend to be geared more toward capital appreciation than income generation. Among U.S. stock funds, large cap value has generated the most interest among investors since the start of the year, which is a bit surprising given the category's poor relative performance generated (compared to large cap growth and large cap blend funds) during the one-, three-, and five-year periods ended December 2012. We have, however, seen more yield-driven flows among sector funds, with domestic real estate funds being the largest recipient of investor capital. That said, interest in funds dedicated to utilities, a more traditional sector for dividend investors, remains low, with more than $100 million flowing out since the start of the year.
Even as the flow picture has improved for actively managed stock funds, it has done little to alter investors' appetite for passively managed equity funds. Based on Morningstar's data, more than $50 billion has flowed into index funds and exchange-traded funds dedicated to stocks since the start of the year, with the flows split fairly evenly among the two investment types. We believe that index funds and ETFs will continue to be the default option for investors looking to gain exposure to equities, despite the flow activity we've seen for actively managed funds since the start of the year, believing that those were actually influenced more by a confluence of fourth-quarter fund sales, special dividends, and a more normalized rotation among asset classes, than a big shift into actively managed funds by investors. The data through the end of February supports this belief, as flows during the month were nearly half what they were in January, with flows for actively managed U.S. stock funds actually turning negative during the month. The data also points to a fair amount of interest in taxable bond funds, which had a near-record year of inflows during 2012, and have been the recipient of close to $1.1 trillion in investor inflows since the start of 2009. More than $52 billion has flowed into these funds since the start of the year, which is on par with the average monthly inflows that we saw during 2012.
We continue to be confounded by this trend, especially with the yield on 10-year U.S. Treasuries hovering around 2.00%, and the 30-year bond yielding 3.25%. At this point, even the S&P 500 Index, which is currently yielding around 2.00%, could be viewed as attractive, given that bond prices are going to fall once interest rates rise. In our view, finding stocks that are yielding more than the benchmark index, but which operate in stable industries, where there is bound to be less uncertainty about their future cash flows, is likely to offer some downside protection for investors. After all, a healthy and safe dividend yield should offer some solace in the midst of market volatility like we've seen over the last four-plus years, and, relative to fixed income, dividend-paying stocks have the potential to produce both higher yields and long-term capital gains for investors.
Widely Held Dividend-Paying Stocks of Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 03-15-13. *Dividends for American Depository Receipts (ADRs) can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends.
While just four of the 22 mutual fund managers on our current list of Ultimate Stock-Pickers-- Amana Trust Income AMANX, Columbia Dividend Income LBSAX, Oakmark Equity & Income OAKBX, and Parnassus Equity Income PRBLX--focus almost exclusively on income investing, plenty of managers look to include dividend-paying stocks in their portfolios. As such, we typically produce a list of more than 500 different dividend-paying stocks each time that we run the data for our top managers. In order to hone in on more than just the holdings that are widely held and yielding more than the S&P 500 (which we reflect in the table above), we whittle down the list of stocks to focus on those that have the highest yields, are held with a greater degree of conviction by our top managers, represent firms with Wide or Narrow economic moats, and have uncertainty ratings of either Low or Medium. In doing so, we believe that we'll be able to highlight firms not only with competitive advantages that will allow them to generate the cash flows they'll need to maintain their dividends longer term, but do so with far less uncertainty. It should also be noted that our dividend yield calculations for both tables are based on regular dividends that have been declared over the last year, and do not include the impact of any special (or supplemental) dividends that may have been paid out during that time.
Top Dividend-Yielding Stocks of Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 03-15-13. *Dividends for American Depository Receipts (ADRs) can be affected by changes in currency exchange rates. Our calculations also adjust for special dividends.
With these two lists in hand, we sat down with Josh Peters, Morningstar's resident expert on dividends, for some insight into the current environment for dividend-paying stocks, much like we did during the third quarter of last year. For those not familiar with Peters, he is the driving force behind Morningstar DividendInvestor, a monthly newsletter dedicated to traditional equity-income investing, and is the author of "The Ultimate Dividend Playbook: Income, Insight and Independence for Today's Investor." Our conversation with Peters went as follows.
The last time we talked, we were still facing a presidential election, as well as the uncertainties surrounding the so-called fiscal cliff at the end of 2012, which coincided with the expiration of the Bush-era tax cuts. How did those events impact dividend-paying stocks during the fourth quarter of last year, and what impact are the ultimate resolutions to those two events having on income-oriented stock investors this year?
The good news is that the uncertainty around dividend taxation has been taken off the table--at least, as much as any policy debate can be. The treatment of dividends and long-term capital gains established in 2003 went through the threat of expirations in 2008, 2010, and again in 2012, but the tax legislation that passed over the New Year's holiday did away with those automatic "sunset" provisions. High earners (households making over $450,000 a year) did see a rise in the tax rate on dividends and long-term capital gains from 15% to 20%. And this year, a tax associated with the Affordable Care Act ("Obamacare") kicks in with another 3.8% levy on these types of income for households making more than $250,000 a year. But compared to the worst-case outcomes--a top federal tax rate as high as 43.4% on dividends--the ultimate result wasn't too bad, and the vast majority of investors weren't affected.
Before the situation was resolved, though, we saw a boomlet in special dividend payments, such as Costco's COST $7/share payment in December. A disproportionate amount of these actions seem to have been motivated by concentrated insiders, mostly at companies (like Costco, in my view) that should have been paying larger regular dividends all along. Since I only buy stocks for generous and growing regular dividends, my portfolio holdings didn't pay any special dividends, and I wouldn't necessarily have been happy if any did. Some other companies pulled a few quarterly dividends that would have been paid in early 2013 into late 2012; Paychex PAYX is the only holding of mine that did that. Fortunately, for most well-established dividend payers, the tax issue didn't seem to figure prominently in their thinking--which is as it should be. After all, it's not the job of CEOs and directors to manage their shareholders' tax bills.
So with all of the tax-related uncertainty issues behind us now, is it fair to assume that the biggest issue that dividend and other income-oriented investors have to deal with going forward is rising interest rates?
That's definitely the top threat for fixed-income securities, and I wouldn't buy long-term Treasuries with Monopoly money. For dividend-paying stocks, the risks are a bit less concentrated. The number-one threat on the horizon is always dividend cuts, and while we haven't had a lot of them since 2009, the ones we've had--including Exelon EXC and CenturyLink CTL thus far in 2013--are always extremely painful and should be avoided wherever possible.
By itself, a normalization in interest rates shouldn't be a terribly strong headwind for higher yielding stocks. It's safe to assume that some yield-oriented money could move back into the bond market, but in the last cycle of rising interest rates (2002-06) dividend-paying stocks performed reasonably well. However, if we see interest rates surge, that could be a bigger problem, especially for REITs.
I think the key to success is to find dividends that provide good yields (3%-5%) with both safety, prospects for dividend growth that exceed inflation, and some hope that if inflation rises, dividend growth will rise in tandem. Setting reasonable expectations should help too; investors probably shouldn't expect sectors like utilities, telecoms, and consumer staples to outperform in a raging bull market. I own them not for their "outperformance" at any one point in the cycle, but for their dividends and dividend growth.
We hear an awful lot from our more income-oriented fund managers about the importance of companies having well-defined and sustainable dividend policies, with most of them looking for established firms that not only generate consistent free cash flow but are positioned to increase their dividend over time. That said, we did get an interesting take on dividends from Ultimate Stock-Picker Warren Buffett in his annual letter to Berkshire Hathaway's BRK.A BRK.B shareholders this year, in which he applauded the dividend policies of his biggest stock holdings, and yet at the same time argued against a dividend for shareholders of his own firm. What did you think about his arguments against not paying a dividend, even as Berkshire carries significant amounts of cash on its books and some shareholders have voiced an interest in receiving one?
To me, Buffett and Berkshire represent the exception that proves the rule. In his 1984 shareholder letter, which also addressed the topic of dividend policy, he was adamant that a dollar of profits retained by a company needed to create at least a dollar of market value. Berkshire, with Buffett allocating the company's capital and incoming cash, easily passes this test. But he's strictly the best at capital allocation, whether it involves acquisitions or even share repurchases, and he can venture into any area of the economy. Other companies, with far fewer opportunities for the profitable deployment of retained earnings, can and should put dividends ahead of acquisitions and buybacks--they need that discipline in order to ensure that shareholder equity and retained earnings are not "free money." In other words, the priorities that work well for Berkshire don't necessarily apply to anyone else.
What did you think of his comment that "dividends impose a specific cash-out policy upon all shareholders," arguing that if "40% of earnings is the policy, those who wish 30% or 50% will be thwarted," as he was making his case against a dividend?
I thought that was a surprisingly weak argument, particularly considering the source. If, unlike Buffett, you're a small, minority, outside shareholder in a company--as the vast majority of us are--then every choice the management makes represents an imposition of some kind. Dividends are actually an exception, as they give shareholders the ability to reinvest and/or spend a portion of the company's earnings as they see fit. Besides, if I want a 30% return and you want 50%, what sense does it make to settle on zero? I doesn't really make much difference to me whether Berkshire pays a dividend or not, but this line of reasoning sets a poor example for other kinds of companies that should be paying much more generous dividends.
Turning away from Berkshire, which we can assume will not be paying a dividend anytime soon, are there companies out there that you think stand out for their dividend policies--good or bad--that investors should be on the lookout for?
With more and more baby boomers retiring, and even lots of younger folks being reluctant to place their faith solely in capital gains, dividend policies are becoming a more prominent consideration for investors than it's been in the past. This makes a company like Realty Income O, so devoted to dividends that its trademarked slogan is "the Monthly Dividend Company," an attractive holding even though the valuation isn't cheap. Ditto for Kraft Foods Group KRFT, which was spun out of the old Kraft Foods (now Mondelez MDLZ) last year. They set a 70% dividend payout ratio right out of the gate, with a plan to raise the dividend at a mid-single-digit pace going forward. Altria MO and Paychex are two more names with great dividend policies--roughly 80% of their respective earnings are paid out as dividends, in part because their internal-reinvestment requirements are so small, but also because their cash flows are so stable. When you run across dividend policies like these, you know that the business exists to serve shareholders rather than the other way around.
At the other end of the spectrum, Google GOOG is now the largest U.S. company by market value that doesn't pay a dividend at all. Their profits are enormous and the free cash flow is even larger, but investors should be concerned about where this cash will eventually go. If it doesn't find its way back to shareholders eventually, those earnings aren't worth as much as people think they are. (Berkshire is the second-largest U.S. company that doesn't pay a dividend.) But even if there is a dividend--and even if the dividend is growing--that doesn't mean it's a priority for management. Take IBM IBM, for example, which raises its dividend every year but yields only 1.6%. This is a slow-growing business that throws off huge amounts of cash, but most of the cash goes toward buybacks rather than dividends. IBM could double or even triple its dividend and put some real money on the table for continuing shareholders, but the buybacks make it look like IBM is a faster growing company (at least on the earnings-per-share line) than it really is. Buffett is a big fan of IBM, but over time, I think fewer and fewer other investors are likely to prefer this emphasis on buybacks over dividends.
It's interesting that you point out Google, as it is now held by 15 of our 26 Ultimate Stock-Pickers, of which only seven are what we would consider to be growth investors (the more traditional buyers of technology stocks). That said, 17 of our top managers also hold Microsoft MSFT, which does pay a decent dividend (yielding more than 3% right now), and as you noted even Buffett has dipped his toes into the technology sector, so there is definitely some interest in the group. Do you look to the technology sector at all when you're looking for dividend-paying stocks, or is it too volatile to support the kind of dividend consistency we see in other sectors, like Consumer Defensive?
There's lots of agreement that the tech sector is cheap, and on a P/E basis you can find plenty of tech giants trading cheaper than utilities. This condition, though, is less interesting than the question of why this is the case. Regulated utilities may not grow very fast, but at least you know what you're going to get--stable, recession-resistant earnings and a nice dividend yield. I look at Big Tech and see a lot of bad capital allocation practices--it's getting better at the margin, perhaps, but it's still pretty bad. Microsoft now yields more than 3%, which is well above the S&P 500, but its business requires very little reinvestment in the form of capital spending. It could easily pay a dividend yielding 6% without hurting its ability to invest for the future. You've still got a lot more buybacks and acquisitions than dividend payments in tech, and a level of cash hoarding that is simply stupefying.
So why doesn't tech pay bigger dividends? It could be that the CEOs are just lazy, and they sleep better at night knowing there's a huge pile of cash socked under the mattress--no matter how much value this destroys for shareholders. Tax policy is often blamed for the offshore cash hoards, but I have to ask how valuable these offshore earnings and cash flows really are if managers aren't willing to repatriate them. Or, getting to your point about consistency, maybe the managers and directors in Big Tech are scared--scared that they'll be displaced technologically and they'll need those giant cash reserves just to survive. I wonder to what extent this explains Apple's AAPL behavior. At any rate, it's not a pretty picture no matter how you look at it.
The only tech stock I own right now is Intel INTC, which has shown the greatest maturity of any large tech company in terms of capital allocation. It's a deeply cyclical business, but its balance sheet and cash flows are strong enough to pay a big dividend even in the down cycles (like the one we're in now) while Intel continues investing aggressively in research and capital spending to keep ahead of rivals. The fact that they're capable of paying a generous and growing dividend isn't particularly unique, but their willingness to actually do so is, which in turn gives me confidence that their long-term success will benefit shareholders directly.
As you may have already guessed, there isn't a whole lot of coalescence around dividend-paying stocks among our Ultimate Stock-Pickers, given that just four of the 22 mutual fund managers on our current list of top managers focus on income-oriented investments. While we could add the four insurance companies, which have a bit of an income bent to their investments, to the mix, we're still looking at less than one-third of our top managers looking at dividend-paying stocks. As such, our list of top 10 dividend-paying stocks, which looks not only at yield, but at each firm's economic moat and uncertainty ratings, has tended to be a bit skewed. Looking back over the last few years, though, the stocks of the drug manufacturers-- GlaxoSmithKline GSK, Merck MRK, Novartis NVS , Eli Lilly LLY, Pfizer PFE, and Johnson & Johnson JNJ--have consistently shown up on our screen (and more often than not were trading at attractive levels). Is there something about the drug manufacturers that makes them more (or less) appealing for a dividend investor?
I can't resist addressing the way you stage the question first. I'm not surprised that there aren't a lot of high-profile "greats" of dividend investing, partly because it's still an emerging area being driven mostly by the country's aging demographic profile. That said, dividend investing is also its own style. It shouldn't be characterized as a subset of value investing, and it's certainly not momentum-driven. I initially approached my portfolios from the perspective of a value investor, but as the years went on I came to understand that successful dividend investing has unique attributes. You can't swing for the fences; no one should expect to double their money in a year or two. You're not going to beat the market consistently either, because high-yielding stocks march to the beat of their own drummer. It's much more of a process of risk control, more akin to fixed-income investing, which plays out over inches rather than miles. And you just don't see many high-quality bargains except during a market crash when everything looks cheap; a consistent winner like General Mills GIS just doesn't get mispriced very often. If growth investors have "GARP," my take on dividend investing is "DARP"--dividends (as well as necessary dividend growth) at a reasonable price.
As for Big Pharma, this is another area where, like tech, I think it's tempting to confuse statistical cheapness with the prospect of good performance going forward. You certainly have some above-average dividend yields in the group, but you don't have much growth, and even a 3% or 4% dividend yield is not going to cut it if the earnings and dividend don't grow. In this group you've got well-defined negatives--patent expirations--but ill-defined positives. There are some promising pipelines, but there's no guarantee that the new drugs will make it to market, or that the set of products that make it to market will be enough to fill the holes left by expiring patents. Johnson & Johnson, which is the only big healthcare name I own right now, has the best earnings and dividend growth prospects of the group, but we're still talking only 6% a year or thereabouts over the next five to 10 years. On balance, Merck and Lilly might not grow their earnings at all. What makes J&J the most appealing stock in the group, in addition to its limited patent-expiration exposure from here, is the broad diversity of its products. They've made some costly mistakes in the area of product quality, but diversification has kept the impact on shareholder value to a minimum.
Looking at another sector with headwinds, and I promise that this is my final question, what is your take on the Financial Services sector? In particular, what is your take on the large banks, most of which have received permission from the Fed to return additional capital to shareholders?
Come on, these questions are fun! But financial services is as good an area to close with as any. Maybe I'm just too darn picky, or maybe I'm still nursing the wounds of 2008, but I can't find a lot to like these days. (Should have asked me about energy instead!)
First, you've got the banks, which have become structurally less profitable thanks to increased capital requirements and heavier regulation, with cyclical compression in spreads thrown in for good measure. For the best banks-- Wells Fargo WFC is my favorite and one of only three banks I own today--you could fairly argue that these circumstances are priced in, and that increased oversight has also brought down risk levels in the industry. But you've still got federal regulators controlling how much capital can be returned to shareholders, with dividends often being limited to just 30% of earnings when 40% or 50% would be a more efficient level. Regulators seem to have a more liberal approach to share buybacks, which are much easier to stop if financial conditions deteriorate, but the experience with buybacks in the banking sector is quite discouraging--shares are bought back in the good times at high prices, only to be reissued to shore up capital when prices are low. The good news is that Wells just put out a 20% dividend increase for the second quarter on top of the 14% hike issued for the first quarter, and the stock now yields well over 3%. It's the only bank stock I would buy today. But banking as a group probably won't ever be as rich with dividends as it was before the crash, which is a double shame in the sense that growth prospects have been crimped too by reduced leverage and a slower-growing economy. With mediocre yields and mediocre growth, I wonder who regulators think these stocks are supposed to appeal to? (More likely than not, regulators don't actually care.)
Elsewhere in financial services, you've got insurance, where there are a handful of decent yields but economic moats are rarely a part of the picture. You can also get a fair amount of leverage and sensitivity to financial asset prices, as I learned back in 2008. (I wasn't in such good hands when Allstate ALL chopped its dividend in half.) Then you've got the specialty financials like mortgage REITs and business development companies, which I absolutely refuse to own. There's nothing about these black-box business models, heavily larded with leverage, that suggests safe and growing dividends through the lean times--and I'm not interested in learning this lesson again. Asset management has become an up-and-comer in terms of dividend yields; BlackRock's BLK franchise and its dividend policy are particularly impressive. But I keep stumbling on what I view as an inflated level for all financial assets (U.S. stocks being far from the worst) and the pressure these firms might face if (when?) the air ever comes out of the balloon.
That leaves the property REITs, which I tend to think of as having fundamentally attractive business models for income investors--but where dividend yields are now abysmally low. Valuations have tracked the plunge in long-term Treasury yields much more closely than consumer staples, telecom or even regulated utilities. Where you can find proven value-creators--and the value flows directly to shareholders through dividend increases--there's still a few stocks worth holding; Realty Income is one REIT that is making the most of a low-rate environment to grow its capital base and its dividend on reasonably attractive terms. But I can't find a good case for chasing a Boston Properties BXP at a 2.5% yield or Simon Property Group SPG at 2.9%; I fear today's buyers will eventually regret paying these prices. Utilities look a little pricey here too, and so do consumer staples and the high-quality telecoms, but REITs strike me as being the biggest outliers in terms of overvaluation.
Since you insisted, and it's an area where our Ultimate Stock-Pickers have been traditionally light (but did actually invest more heavily last year), tell us what you like in the Energy sector these days.
You don't find many dividends among the smaller exploration & production (E&P) companies, but a couple of the supermajor dividends are quite attractive. It'd be a mistake--as I made for many years--to think of Big Oil as being a pure play on the direction of energy prices; capital allocation is just as important. Chevron CVX, one of my top holdings, is extending its record as a highly effective allocator of capital. It has raised its dividend for 25 straight years, yields 3% with another nice dividend increase on tap within a few months, and has ploughed its excess operating cash flow into a very successful E&P program.
Meanwhile, Royal Dutch Shell RDS.A RDS.B is probably the most attractive way to get a safe 5% yield in any sector of the economy right now. Shell's dividend won't grow as fast as Chevron's, and they've had more trouble (particularly as an even larger company) replacing the reserves they pump out of the ground every year. Still, Shell has some big projects coming online, they're on track to keep growing the dividend around 5% a year, and there's upside to their dividend growth rate if inflation takes hold and drives up global oil prices. Some investors, particularly in Europe, are disappointed that Shell's dividend isn't larger than it is, but management doesn't want to get caught in a squeeze between the dividend and continued exploration activities if oil prices plunge like they did in 2008--a wise tradeoff, in my view. I hesitate to call any stock a "no-brainer" but Shell comes pretty close; I just bought some more shares in early March.
Even better income candidates can be found in the midstream sector--pipelines, storage facilities, terminals and the like--where most of the companies generate a lot of reliable cash flow. Many of these are structured as master limited partnerships (MLPs) and pay out most or all of their cash flow, but again we find the best capital allocators--especially Magellan Midstream Partners MMP and Kinder Morgan Energy Partners KMP--finding new ways to keep their cash distributions rising at a good clip. The drawback at the moment is that the highest-quality MLPs like Magellan aren't all that cheap--you're shocked, I know!--and the ones that do look cheaper, like Boardwalk Pipeline Partners BWP, have poor growth prospects. You've also got to be on your guard against more volatile businesses, like E&P operations or spread-based natural-gas processing, that are part of some MLPs. But two of the pipeline operators that are structured as ordinary corporations, Spectra Energy SE and KMP parent Kinder Morgan KMI, offer solid yields around 4% and high-single-digit long-term dividend growth prospects. These don't come with any of the unusual tax consequences of owning MLPs, making them good picks for tax-deferred accounts.
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Disclosure: Greggory Warren owns shares of the following securities mentioned above: Amana Trust Income, Kraft Foods Group, Mondelez, Altria, and General Mills. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.