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Investors are cashing in on dividends. Companies in the S&P 500 raised dividends by $8.8 billion in the third quarter and paid a record $70.1 billion, according to Standard & Poor's.
With large companies yielding around 2.6%, investors can earn more income from these stocks than they can from high-quality corporate bonds — and far more than the 1.7% yield on a 10-year Treasury bond. Yet instead of simply buying high-yielding stocks, some veteran investors suggest a slightly different approach: focusing on "payout ratios" as a way to tap into potential dividend growth.
A payout ratio is the percentage of profits a company pays out in dividends, and it offers vital clues about how sustainable the current dividend is and whether a company can grow its payout going forward.
Companies with high payout ratios — say, above 80% — may have trouble maintaining and raising their dividend if their business slows. They also may have to finance future growth and dividend payments with external sources of capital, which can weaken their balance sheets or dilute their equity. This capital may not even be available if the economy falls back into recession and their business slows.
"If you pay out everything you earn, there's nothing left to re-invest in the company and grow earnings," says David Ruff, lead manager of the Forward International Dividend Fund (FFINX).
Low payout ratios, by contrast, provide a cushion against dividend cuts and enable companies to return more cash to shareholders — ideally through higher dividends. Ruff, for one, argues that payout ratios between 30% and 60% are ideal.
Below those levels, a company may be hoarding cash, which is fine if it's making wise investments. But companies often squander cash on acquisitions or projects that don't return more than their cost of capital. Paying out more cash keeps management "disciplined," says Ruff, and puts money directly into shareholders' pockets.
The good news for investors: Payout ratios for U.S. stocks are low. Companies in the S&P 500 are paying just 34% of earnings in dividends versus 52% historically, according to S&P. Even with corporate profits expected to decline in the third quarter, most companies should be able to keep raising dividends, says Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. Indeed, S&P expects dividend payouts to hit $72 billion in the fourth quarter, which would be a 2.7% increase over the prior quarter.
Dividends don't just generate income for shareholders: They're a powerful driver of total returns. In the 20th century, investing in U.S. stocks and reinvesting their dividends produced more than 84 times the return of a portfolio without reinvested dividends, according to research from Fidelity Asset Management.
More recently, dividends have played a lesser role as investors have bid up growth stocks, which typically have very low yields. But dividend payers typically outperform in sideways or down markets because investors want companies with stronger cash flows and balance sheets.
Ironically, the highest-yielding stocks aren't always the biggest winners. Rather, stocks with a high yield and low payout ratio appear to generate the strongest returns, according to a study by Credit Suisse. The company examined quarterly returns in 12 countries from 1990 to 2012. In nine of the 12 countries, the stock markets with a high yield and low payout ratio provided the highest average returns, and these countries outperformed over a full market cycle, including bull and bear markets.
Another way to slice the dividend universe is to look at companies that consistently raise their dividends. Standard & Poor's maintains a list of 51 dividend "aristocrats" — companies in the S&P 500 that have increased their dividends every year for at least 25 consecutive years. Since 2000, these stocks have returned an average 8.5% a year versus 1.7% for the index through Oct. 3, according to S&P. In total, the aristocrats returned a cumulative 184.7% versus 24.8% for the market.
The SPDR S&P Dividend ETF (SDY) tracks the performance of the S&P High Yield Dividend Aristocrats Index. Returns for this ETF have been middling in recent years as growth stocks have outperformed. Still, it offers exposure to a basket of dividend growers and yields 2.9% -- above the market average.
If you want to buy individual stocks with potential dividend growth, many market pros recommend stable businesses with revenue streams that can withstand economic downturns. Two of the largest S&P aristocrats are cash-flow giants: ExxonMobil (XOM) and Johnson & Johnson (JNJ), with payout ratios of 22% and 63%, respectively.
Others are leading consumer product businesses, such as Clorox (CLX) and Procter & Gamble (PG), or they dominate niche markets, including scrap-steel company Nucor (NUE) and industrial coatings supplier PPG Industries (PPG). Yields for some of these stocks may be low, but they produce more than enough cash flow to cover their dividends, even in a modest downturn, says Silverblatt.
Remember that payout ratios tell only part of the story. Economically sensitive industrial stocks may have low payout ratios when earnings are at their peak but these firms may cut dividends as profits fall.
Moreover, higher dividends often mean a company is transitioning from rapid to slower growth, says Thomas Forester, manager of the Forester Value Fund (FVALX). Investors need to ratchet down their expectations for these stocks as their growth slows and they become known more as "value" stocks.
One stock Forester likes for its total-return potential is CVS Caremark (CVS). Right now it yields just 1.3%, but its payout ratio is a skinny 20%. The drugstore chain and pharmacy benefits manager has invested heavily in its business and is now building cash in a "reaping" phase, says Forester. That should benefit shareholders as the company raises its dividend and returns more cash to shareholders.
Amgen (AMGN) also looks promising, he says. The biotech company yields about 1.7% but its payout ratio is a minimal 12%. Earnings per share are forecast to grow 8.7% next year and the stock trades around 13 times estimated earnings, a discount to the market.
One place to look for more yield is overseas, though there are several things to keep in mind. Foreign stocks are generally cheaper than U.S. stocks based on price-earnings ratios, and there's a wide dividend gap as well. Dividend payers in developed foreign markets now yield 5.2% compared to 2.6% for U.S. payers — a gap that's persisted over the past decade.
Yields are higher overseas for several reasons. In Brazil, companies are required by law to pay out at least 25% of earnings in dividends. Tax policies in New Zealand and Australia favor higher dividends. And in countries that have battled high inflation, investors demand higher payouts in order to earn "real returns" above the inflation rate, says Ramona Persaud, manager of the Fidelity Global Equity Income Fund (FGILX).
As tempting as overseas dividends may seem, investors shouldn't chase yields in foreign markets. The Spanish market yields 6.5%, for instance, but its payout ratio is an unsustainable 150%. Investors should seek to strike a balance between yield, payout ratio and growth, says Persaud.
"If you can combine a high yield with a low-to medium payout ratio and dividend growth, you improve the odds of strong total returns over time," she says. "That's the trifecta."
Of course, foreign stocks have their pitfalls. Their dividend payments tend to be less regular than U.S. payouts. That's because foreign companies typically establish annual dividend payments based on payout ratios, which fluctuate with earnings. Even if a company hits its target, currency fluctuations can kill returns for U.S. shareholders. "These are not bonds," says Forward's Ruff.
One strategy to reduce risk involves buying U.S. stocks for their low payout ratios and potential for dividend growth, while going abroad for extra current yield. That's how Persaud manages her fund, and she says the strategy can produce higher returns with less risk than buying a basket of high-yielding foreign stocks.
If you're going to invest abroad, three appealing markets are the United Kingdom, Germany and Switzerland, according to Alec Young, global equities strategist for S&P Capital IQ. These markets have estimated 2013 yields of at least 4%, according to consensus forecasts, and payout ratios of 40%, 52% and 55%, respectively. That's an income "sweet spot," says Young, indicating companies in these markets can make their dividend payments without stretching financially.
Investors can tap these markets through country ETFs like the iShares MSCI United Kingdom Index Fund (EWU), iShares MSCI Germany Index Fund (EWG) and iShares MSCI Switzerland Index Fund (EWL). Expense ratios for these ETFs are 0.52% and they yield between 1.6% and 3.3%. Bear in mind, country ETFs are riskier than a global index fund, which is more diversified.
With much of Europe teetering on recession, it might seem like a region best avoided. But some managers are finding European stocks too cheap to pass up.
One British stock that looks promising, according to Ruff: supermarket chain Tesco (TSCDY). Though competition is heating up in Tesco's home market, its international business is growing roughly 20% a year. The payout ratio is 40% and the stock trades around 10 times consensus 2013 earnings estimates, while yielding 4.6%.
Another European stock to consider is French insurance company AXA (AXAHY), says James Moffett, a 40-year veteran of foreign stock investing who co-manages the Scout International Fund (UMBWX). Prices for some insurance lines are strengthening and the company is expanding its presence in emerging markets. Its payout ratio is 58% and the stock yields 6%. "Its prospects are improving," says Moffett, "and you can get paid to wait."
Even emerging markets now offer a compelling mix of income and growth. The iShares Emerging Markets Dividend Index Fund (DVYE) currently yields 4% and is well diversified across sectors and countries. Earnings per share for emerging markets are forecast to grow 10.7% in the next 12 months, according to consensus estimates, and dividends are expected to grow a handsome 13%.
"Emerging markets have higher yields than the U.S., lower valuations and better growth prospects," says Ruff. For long-term investors, that could be a winning combination.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services.
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