Millions of income-hungry investors are turning to dividend-paying stocks these days, yet dividend investing can backfire if the underlying business isn't growing — dragging down the stock and an investor's total returns.
One place to get that Goldilocks mix of growth and income? Large technology stocks.
While the tech sector isn't known for high yields, several of the biggest names in the industry now pay a dividend, with some stocks yielding nearly 4%. In an era of low rates, that beats 10-Year Treasuries and many quality corporate bonds.
Even a small yield can add powerfully to returns. Though the S&P 500 (.SPX) remains below its 2007 peak, it has returned a cumulative 84.88% over the last decade, including an average yield of 1.97%, according to S&P; strip out that dividend income and the return drops to 51.30%. Most tech companies don't pay a dividend, of course. Businesses in the early stages of their growth cycles need to plow earnings back into the business, and many tech firms are too small to pay out a meaningful percentage of their income to shareholders.
Cash, cash, cash
Yet at the top of the tech food chain, times have changed. Many of the biggest players in the industry now have strong balance sheets and lots of cash they don't need to reinvest in the business. That leaves plenty of money for acquisitions, stock buybacks or — in what's often the best use for shareholders — dividend payments.
"As a general principle, dividends have much lower volatility than earnings and are a very consistent way of returning cash to shareholders," says Scott Offen, a Fidelity Investments portfolio manager who runs the Fidelity Equity Dividend Income Fund (FEQTX).
More companies are getting with the program: 28 tech companies paid a dividend in 2012, up from 24 in 2011. And payments are expected to reach $25.6 billion this year, a 14.3% increase from 2011, according to Moody's Investors Service. Tech companies' payout ratios — the percentage of earnings paid out as dividends — generally are low as well. That helps ensure investors get paid even if the business slows, plus it leaves room for companies to hike the dividend, giving shareholders a raise.
Granted, many tech companies are reporting weaker profit growth as the global economy slows. Austerity measures are shrinking government spending on technology in the U.S. and Europe. Growth is holding up better in emerging markets, but not enough to make up for the slowdown in the developed world. A number of large tech companies also are in the midst of turnarounds and are likely to report lower earnings as they restructure.
At the same time, many large-cap tech stocks look cheap relative to their earnings. Price-earnings ratios are below their five-year averages in many cases. And P/Es look even lower when factoring in the cash that companies have built up on their balance sheets (see Apple below).
While tech company profits tend to rise and fall with economic growth, there are pockets of growth that are less tied to the economy. Some software companies, for example, are seeing strong demand for products based on trends like the rise of cloud computing and data analytics. In addition to being less economically sensitive, their business models also tend to be asset-light and require less capital, which can help them stay profitable even if demand slows.
Owning individual stocks is riskier than buying a mutual fund or ETF, of course, and even tech heavyweights can stumble (just look at Nokia (NOK)). One way to lower risk is to own a diverse mix of companies.
Fidelity's Offen likes to put dividend stocks into buckets: He buys some for growth, others more for income, and tries to maintain a balance between cyclical stocks and companies with slower but stable growth. "Everyone would rather own something growing 30% a year," he says, "but you have to make tradeoffs between yield and growth."
For buy-and-hold investors with a long time horizon, here are five big tech names to consider:
- 5-year earnings per share growth rate: 64.95%
- Dividend yield: 1.71%
- 1-year forward P/E: 11.8
Apple's (AAPL) stock performance has been extraordinary – it has soared 53% this year alone – and its $580 billion market value is now bigger than the economy of Switzerland. Remarkably, the iPhone and iPad maker still looks cheap by some measures. The stock trades at less than 12 times estimated fiscal 2013 earnings and 9.4 times earnings if you strip out the company's cash and investments, which amount to around $123 per share.
The big question is whether Apple's hot streak can continue without Steve Jobs. Setting aside the company's product hit parade, competition is heating up. Rivals like Samsung (locked in a patent war with Apple) are chipping away in the smart phone arena, and tablets equipped with Windows 8, expected later this year, could weaken the iPad's dominance in that market.
Apple does have some key competitive advantages: massive leverage over component suppliers that helps it hold down costs; an ecosystem of trendy products and services that has become entrenched with consumers, and product designs considered some of the finest in the industry. Indeed, most analysts forecast record sales for the upcoming iPhone 5, expected in September, and Apple has been gaining share in the PC market with its Macs.
Simply put: "You have to watch it closely, but Apple is an exceptional company with a convincing investment case and fantastic track record," says analyst Nicholas Landell-Mills of independent stock research firm Indigo Equity Research.
- 5-year earnings per share growth rate: 8.85%
- Dividend yield: 2.78%
- 1-year forward P/E: 4.3
Hewlett-Packard (HPQ) has been the biggest dog of the Dow this year, tumbling 24%. The computer and printer maker has had four CEOs in roughly two years (the latest in the hot seat: Meg Whitman, formerly of eBay (EBAY)). Sales and earnings have frequently missed estimates and HP's position as the world's largest PC maker may soon be eclipsed by China's Lenovo (LNVGY), which has been catching up fast.
So why buy the stock? It's dirt cheap, for one thing. At less than five times estimated fiscal 2013 earnings, expectations are so low that even if earnings decline another 20% to 30% in the near term, there's not a lot of downside in the stock, says Larry Pitkowsky, co-manager of the GoodHaven Fund (GOODX), which owns HP shares.
Despite its troubles, the company has lately generated free cash flow of around $8 billion a year, he says. It has valuable intellectual property assets and could get a boost from the upcoming launch of Windows 8, which is expected to drive an upgrade cycle in PCs and could help HP gain traction in the tablet market.
"It's like a World War II battleship that has taken some hits," says Pitkowsky. "But they're turning it around."
- 5-year earnings per share growth rate: 16.60%
- Dividend yield: 1.70%
- 1-year forward P/E: 12.0
With its wide array of hardware, software and services, IBM (IBM) is closely tied to global technology spending. That may be a headwind as spending growth slows. But Big Blue's business has become less tied to these cycles: 52% of sales and 60% of profits now come from businesses with recurring revenue streams, such as services and software.
In addition, growth markets outside the U.S. and Europe make up a rising share of IBM's sales, and profitability is getting a lift from the company's shift into higher-margin products like software.
IBM's revenues in the second quarter fell 3% from a year earlier and analysts expect sales to dip slightly this year to $105.3 billion. Growth is expected to pick up next year, however, and IBM has consistently grown earnings, which are forecast to increase about 10% in 2013. Analysts also expect the company to boost the dividend 8.6% from $3.24 to $3.52 a share.
"It's not the cheapest stock but it's a good solid play that should have continued growth," says Tom Forester, manager of the Forester Value Fund (FVALX), which owns IBM shares.
- 5-year earnings per share growth rate: 7.01%
- Dividend yield: 2.64%
- 1-year forward P/E: 10.0
Microsoft's (MSFT) growth may never return to the glory days of the early PC era. But as it enters corporate middle age, its Windows operating system and Office software still dominate the global PC market. Its server and tools business is growing at a clip of 10%-plus. And there are high expectations for Windows 8, the upcoming operating system designed to tie in PCs, tablets and mobile devices.
Analysts expect the system to finally make Microsoft a strong competitor in the tablet and mobile phone markets, and it should get a lift in its core enterprise market as businesses buy the new software for workplace PCs.
"Windows 8 doesn't have to take over the world," says Forester, who owns shares of Microsoft in his fund. "It just needs a foothold to reach critical mass."
While Microsoft's growth has slowed, it is still a cash machine: Revenue climbed 5.4% to $73.7 billion in fiscal 2012 and free cash flow reached $23.1 billion. Microsoft now has $63 billion in cash and short-term investments on its balance sheet.
And the stock looks cheap at 10 times estimated fiscal 2013 earnings, according to Forester. "There's a ton of potential in the company, on top of what they're already doing," he says.
- 5-year earnings per share growth rate: 2.31%
- Dividend yield: 3.93%
- 1-year forward P/E: 20.3
Payroll processing has become so high-tech that many small and midsize companies no longer handle it themselves. Instead, they outsource it to Paychex (PAYX), the second-largest payroll processor in the country, with 567,000 clients. Once a company hires Paychex, it usually doesn't leave because switching vendors can be costly and difficult.
That creates stable, recurring revenue streams and a competitive moat for Paychex to thwart potential rivals. Plus, since it's basically a software business that doesn't require heavy capital investment, it's quite profitable: Returns on invested capital have averaged 37.5% over the past five years and profit margins have averaged 25.4%.
True, Paychex tends to do better when job growth is robust, which it currently isn't. And it's earning less money on the payroll cash it holds for employers since interest rates are so low. These issues have pressured earnings in recent years, which have been below the average growth of 7.59% over the last decade. Still, Paychex has managed to eke out modest revenue and profit growth in a difficult environment, and Wall Street expects earnings to increase 6% to $1.61 a share in fiscal 2013.
With a P/E ratio around 20, Paychex's stock trades at a premium to the S&P 500 (.SPX). The stock's P/E is on par with its five-year average, however, and earnings growth could pick up in the next few years. A new management team recently took over, aiming to improve profitability, and the company has good opportunities to sell more services to existing clients, says Morningstar senior equity analyst Vishnu Lekraj. Paychex also pays out around 80% of earnings in dividends, providing a steady cash stream to investors.
Says Lekraj: "It's like a high-quality bond with some upside in the equity."
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.