As interest rates have hit generational lows inthe last few years, investors’ appetite for dividend-paying stocks hassoared. Since the cyclical high for the 10-year Treasury in April of 2010 (itwas 3.98%), the yield on the 10-year has dropped by 37% to 2.50% while theS&P High Yield Dividend Aristocrats Index has returned 63% (source:Bloomberg). This large drop in yields has shifted many investors towardshigh-yielding stocks as an income or bond substitute.
The Advantage of Dividend-Paying Stocks
NewFocus Financial Group has always been astrong believer in stocks that pay dividends. This is the case for a numberof reasons but the biggest two are:
- Dividends help align management andshareholder interests by making management focus on efficient uses of freecash flow.
- As the chart below shows, the long-termreturns of the S&P 500 Index are boosted dramatically by dividends.
Source: NewFocus Financial Group and Bloomberg
Just focusing on companies that pay a high dividend alone can lead to unintended investment results.
Focus On a Company’s Overall Health
However, just focusing on companies that pay ahigh dividend alone can lead to unintended investment results. Many times astock that offers a high yield does so as a result of a declining share pricethat has caused the yield to increase, or the company’s board has increasedthe dividend to a point where either future increases are unlikely or thedividend is outright unsustainable. An example that comes to mind is a firmlike Annaly Capital Management. This firm is a real estate investment trust(REIT) and like most REITs pays a high dividend (currently 11.57%). For anyinvestor who was looking at this company back in October 2010 when it was payinga 68 cent per share quarterly dividend, examining the firm’s dividend healthwould have proven to be a worthwhile exercise. Fast forward to the company’smost recent dividend declaration and the quarterly payment has dropped to 35cents while an investor would have realized a total return of roughly -3.00%over the three years even with that high dividend payment. This is one reasonwhy it is extremely important to focus on a company’s dividend health andfinancial resources when choosing dividend-paying equities.
A Long-Term Approach
Firms that exhibit consistent dividend increasesalong with healthy balance sheets, consistent and growing free cash flow, andlower dividend payout ratios will tend to have greater flexibility inincreasing dividends than firms that are experiencing deterioration in someof these key financial metrics.
While an investor will most likely give up someincome by not chasing the highest-yielding stocks in the short term, focusingon a company’s ability to grow their dividends over time will usually be morerewarding from a total return standpoint over the long term.