Everyone’s out for dividends these days…
Looking back 15 or so years ago, that wasn’t always the case.
“In the late 1990s, when tech stocks were the hottest thing, nobody wanted to touch dividend stocks. Now, people can’t get enough of them, and it’s not likely to let up soon,” observes S&P’s Senior Index Analyst, Howard Silverblatt.
Dividend payers are giving the throngs of dividend investors exactly what they want, too…
As Silverblatt also points out, the S&P 500 has never paid more dividends than now. This year it’s on pace to pay out a record amount: $277 million, or about $29.02 per index share.
But don’t think for a minutes that it’s just the recent craze driving the value of dividends because great dividend performance isn’t anything new.
Historically, dividends have always been a solid investment. According to Hartford Mutual Funds, “Over the past eight decades, dividend income’s contribution to the total return of the S&P 500 Index averaged 45%.”
Still, because dividends are so popular right now, investors need to be especially diligent at ignoring the losing strategies that crowds often follow.
At bottom, if you identify excellent sectors and the outstanding dividend payers in those sectors, you have nothing to worry about. (Matthew Weinschenk recently outlined three great sectors worth your attention. And Jason Simpkins showcased three stocks with high yield and a solid dividend history.)
It’s a foundation that, as Justin Fritz points out, we’re absolutely committed to at D&I Daily. “The main focus of our strategy is to pinpoint stellar companies that pay out attractive but safe dividends. They’re the key to long-term investing success. It’s that simple.”
In other words, chasing high yield simply isn’t enough. Other standards have to be applied to ensure long-term performance.
Here are three qualities that make an excellent dividend payer stand out from the rest …
~ Key Quality #1: Moderate Dividend Payout Ratio
To reiterate, high yields aren’t the only thing to look for in a stock. In fact, high yields can be a warning of an unreliable dividend payer.
One measure of this potential unreliability is the dividend payout ratio. The dividend payout ratio indicates how much of a company’s earnings are paid out as dividends. When the ratio trends higher year-over-year, there’s a distinct possibility that you have an unreliable payer on your hands.
It’s really just a measurement of how long the good times can roll. When a company increases its dividend payouts faster than it increases earnings – this would mean a dividend payout ratio continually trending upward – you can expect those payouts to eventually hit a brick wall, resulting in cuts and a limit to future dividend growth.
If you’re looking for long-term, stable and increasing yields, a moderate and steady dividend to earnings payout ratio (up to 80% is acceptable) is a sign of future growth.
~ Key Quality #2: Significant History of Dividend Increases
Not only should you look at the historical dividend payout ratio, you should at the past five to 10 years to determine if a company’s had a history of dividend increases.
If a company’s been increasing payouts consistently for a significant period of time – even if its dividend yields are initially low – over the long term you’re probably in for a very significant return of capital.
Warren Buffet’s investment in Coca-Cola (NYSE: KO) is a classic example. When Buffet made his first initial share purchase, Coca-Cola was a meager dividend payer, but Buffet saw the forest for the trees:
“Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.”
His point? Growth and fundamentals matter most in dividend investing. If you land on a company that’s going to consistently increase its dividends while thriving as a business, you’ll have a lifelong dividend payer to look forward to.
~ Key Quality #3: Share Buybacks
Lastly, even if a company is raising its dividends, it might be doing so while actually decreasing the value of its shares.
Such a practice obviously dilutes the value of those shares and counterbalances any gains that shareholders realize from dividend increases.
It’s the polar opposite of that practice that you should search for. Dividend increases plus share buybacks are one sign of a stellar dividend payer. Not only are you reaping the rewards that dividends offer, you’re seeing the underlying value of your shares increase, as well.
A recent example of this, no doubt known by now to every investor the world over, is Apple’s (Nasdaq: AAPL) recently announced dividend payment and share repurchase plan. Sitting on an almost unseemly mountain of cash, it committed itself to not only initiating a quarterly $2.65 per share dividend, but a $10 billion share repurchase, as well.
Another example is Eli Lilly (NYSE: LLY). To begin with, the company has an excellent history of increasing dividends. But since 2001, it’s also been in the process of buying back $2.58 billion worth of shares. With only $420 million left to go, it’s on track to complete the repurchases by the end of this year.
Not to mention that following the completion of the current buybacks, the company anticipates another repurchase program to follow.
Bottom line: While the crowd simply chases yield, smart income investors should take into account three key fundamentals – payout ratios, dividend increases and share buybacks – to ensure they’re buying the best long-term dividend payers.