For investors seeking an income alternative to the low yields offered by bonds and CDs, dividend stocks may be an answer. In exchange for higher yields, equity investing has historically meant more risk than bond investing, but there may be ways to manage that risk, including careful inspection of the dividend payout ratio—the percentage of earnings a company pays out in shareholder dividends. This data point may be able to help identify stocks with lower prospective volatility than that of the market, competitive income levels to bonds, and strong dividend growth potential.
"We have found that there’s a sweet spot for payout ratios," says Matt Fruhan, manager of the Fidelity® Growth & Income Portfolio (FGRIX) and co-author of a recent report on dividend payout ratios. "High-quality companies with a payout ratio in the 40% to 60% range tend to have higher valuations, lower volatility, and lower cost of capital than the rest of the market. We’re looking for companies that can move into the payout ratio sweet spot over the coming years and receive the potential benefits associated with it."
The case for payout ratio
Looking at a high-quality subset of the S&P 500® Index, consisting of 298 companies with a history of stable, positive earnings1—the kind of business solidity required to increase dividends consistently over time—the study found that firms with a payout ratio from 40% to 60% had several advantages over their peers:
Higher stock values. Companies with higher payout ratios generally traded at higher price-to-earnings (P/E) multiples than companies with lower payout ratios. Companies that increased their payout ratios during the period under review received an increase in their multiples, even as P/Es shrank on the rest of the market.
The premium multiples on high-payout stocks stem in part from the market’s current hunger for yield—hence the elevated P/E on stocks with the highest ratios. "Bonds are expensive, and so are stocks with bond-like characteristics, including many utilities," notes Fruhan. "These stocks aren't very attractive to me. They offer high yields, but there’s little room for them to increase their payout ratios. We want to find companies that haven't implemented a higher payout strategy yet, but have business models that could support higher payouts—and might get a lift in their valuation if they do so," he adds.
Less volatility. Beta describes a stock’s volatility relative to the market as a whole. The Fidelity research showed that companies with a payout ratio from 40% to 80% had betas almost 30% lower than the overall market, likely because these companies have exceptionally stable businesses. But there also seems to be a cause-and-effect relationship between increases in payout ratios and declines in volatility: Companies that increased their payout ratio into this sweet spot saw their stocks’ beta decline significantly, while the beta on the rest of the high-quality universe rose—meaning investors found less volatility in stocks with increasing dividends, even as the rest of the dividend stock market experienced more exaggerated ups and downs.
A competitive advantage. Companies with a payout ratio from 40% to 60% had the lowest cost of debt, as measured by spreads on their bonds' credit-default swaps (CDS), according to the study.
"You might expect bondholders to prefer companies that hoard their capital and keep it available to service debt," says Fruhan. "But debt costs actually went down when companies increased their payout ratios to between 40% and 60%. We think the bond market interprets a payout ratio in this range as an indication of good capital allocation."
The combination of low debt costs and low beta gives these companies a structural, long-term advantage over competitors through a lower overall cost of capital. With this lower cost of capital, companies may be able to pursue reinvestment in their business or opportunistic acquisitions at better terms than their competitors can.
Putting it all together
Reviewing each of these three factors reveals that there is a sweet spot in the payout ratio from 40% to 60%, where multiple benefits are maximized. In this range, investors can capture higher P/E multiples, lower volatility, and lower cost of debt than the market as a whole.
"There’s a strong investment case for looking at companies that are not yet in this payout ratio sweet spot," says Fruhan. "We're especially interested in companies that have demonstrated an appetite to return capital to shareholders through payouts, but haven’t optimized their ratio yet. When they do optimize it, their valuations are likely to increase along with their dividends—a double whammy for shareholders—at the same time their cost of capital declines."
How to use the payout ratio
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There's no shortage of candidates that might move into the sweet spot: Some 65% of the companies in the high-quality subset of the S&P 500 Index have a payout ratio lower than 40%.
Fruhan and Naveed Rahman, institutional portfolio manager, believe many companies are likely to increase their ratio in the years ahead. From 1980 to 1999, the S&P 500 as a whole had a median payout ratio of 45%; last year it was much lower—ending the year at 32%. That could suggest room to move up. Meanwhile, companies have extremely healthy balance sheets, with low debt and historically high cash positions. "Corporations are awash in cash, profit margins are at an all-time high, and companies are starting to think about returning money to shareholders," says Fruhan.
One caveat: When using payout ratio, it's essential to focus on the future. "This is not an exercise in looking at yesterday's or today’s dividend payers," says Rahman. "One of the risks is that you fixate on companies that increased their payout ratio in 2011 or 2012, rather than on those that can flex their capital allocation going forward."
Caveat number two: Consider interest rate risk. "If interest rates rise, some of the high-P/E, high-payout ratio, bond-like equities could see their valuations fall," warns Fruhan. "So I try to find companies with earnings that are insulated from a rising-rate environment, or that can even benefit from it."
Companies that fit the profile
Certain types of firms are especially likely to fit the mold. Fruhan observes that distribution companies often benefit from inflation, which is likely to accompany any rise in interest rates. Service companies tend to generate recurring revenue, which provides the stable cash flow needed to sustain an increased payout ratio. Many software and media companies have the requisite combination of reliable revenues and low capital needs.
Fruhan currently is bullish on financials, many of which are likely to benefit from higher interest rates. He notes that regulators depressed many financial companies' payout ratios following the financial crisis, but are beginning to allow greater payouts. "Now balance sheets, capital ratios, and liquidity ratios are much healthier," he says. "The potential systemic risk has gone down dramatically. And you have regulators monitoring the health of the businesses and allowing them to return more capital. So as financial companies' earnings grow from the current extremely challenging environment, you’ll see payout ratios start to climb to 30% or 35%."
"There are plenty of companies at attractive valuations to choose from that have a 20% to 35% payout ratio, current dividend yields from 2% to 3%, and earnings growth in the high single or low double digits," continues Fruhan. "Investors have many opportunities to benefit as firms move into the payout ratio sweet spot."