A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week

September 15, 2014

Equity Income: beyond yield
Top 100 S&P 500 companies by dividend yield and 5-yr dividend growth rate

chart

Source: Bloomberg, as of 9/8/14. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • Given today's historically low bond yields, income-generating equities offer yields that represent a competitive, if not attractive, complement to low-yielding traditional bond sectors.
  • There's more to equity income investing than just seeking the highest yielding stocks, of course. The growth of dividend payouts is also a critical consideration; a high yield can reflect a healthy business, but also one whose stock price is under pressure.
  • Income aside, the capital appreciation potential in stocks is also worth considering. While future price appreciation in bonds may now be constrained by the low absolute level of yields, the prospects for earnings growth leaves the door open for a greater level of price appreciation in stocks.
  • Determining which companies with high dividend yields will be best positioned to sustain them – and which will be able to maintain high rates of dividend growth – require in-depth analysis of the underlying businesses.
  • That illustrates the value of a fundamental, bottom-up approach to active stock selection – especially at a time when many stocks are considered fairly valued, and a growing focus on dividends may be increasingly reflected in valuations.

The chart:

  • The chart shows the median gross dividend yield, median 5-year divided growth rates and median 12-month forward P/E of two selections of S&P 500 companies and the S&P 500 as a whole.
  • The first selection is of the top 100 companies grouped by highest gross dividend yield and the second is of the top 100 companies grouped by highest dividend-growth rate.
  • As of September 8, 2014:
    • The companies with the highest dividend yields had the lowest median dividend growth rates, but a modestly lower median forward P/E.
    • The companies with the fastest dividend growth rates had a median dividend that was in line with the median dividend yield of the overall index, but notably lower than the highest yielders.
    • The companies with the fastest dividend growth rates had a median dividend growth rate that was significantly higher than the median of both the index and the highest yielders, but a forward P/E that was slightly higher.

Context & Perspective:

  • Many dividend stocks offer a competitive yield alternative to traditional fixed-income securities.
  • Companies have been raising their stock dividends in recent years, but despite the hikes, the aggregate dividend payout ratio remains well below historic average levels.
  • Meanwhile, with high levels of cash on their balance sheets—and with the support of solid cash flows—corporations could be in good financial position to keep increasing payouts. If investors were to attach a valuation premium to dividend growth, it could become an incentive for management teams to deliver more of what investors want.
  • While a high dividend yield can certainly be a good thing in many cases, the growth rate of those dividends might be just as important. For example, a high dividend yield by itself could simply reflect a battered stock price of a struggling company that will soon have to reduce its dividend due to poor management of its balance sheet or inability to turn a profit.
  • On the other hand, a solid, consistent dividend growth rate could indicate the ability to generate consistent free cash flow above and beyond what's needed to effectively grow the business.

Definitions:

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.

The dividend payout ratio is the percentage of earnings paid to shareholders in dividends.

Free cash flow (FCF) is measure of financial performance calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

The price-to-earnings (P/E) ratio is a stock's (or index's) price divided by its earnings per share (or index earnings). The forward P/E ratio is a stock's (or index's) current price divided by its estimated earnings per share (or estimated index earnings), usually one-year ahead.


The opinions and views expressed herein, as well as references to individual companies or securities, are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or recommendations to buy, hold or sell, or investment advice.

Past performance is not a guarantee of future results.

All investments involve risk, including possible loss of principal.

Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market fluctuations.

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

Dividends and yields represent past performance and there is no guarantee they will continue to be paid.

Active Management does not ensure gains or protect against market declines.

Diversification does not assure a profit or protect against market loss.

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