Yield of Dreams or an Investor’s Nightmare—Dividend Considerations

With short term money market rates yielding virtually zero and the 10-year Treasury note yielding about 2.2% it’s no surprise that investors have declared war on low rates and are looking to the stock market for fatter yields.

Much has been written about the impact dividends have had on the total return to investors. Generally, dividends contribute 40-50% of an investors annualized returns each year (when looking at the market as a whole). Over the past 80 or so years, the S&P 500 has produced an annualized return of about 9.5 percent—5.3% coming from price appreciation and 4.2% from dividend contributions. However if you reinvested those dividends each year, the compounding effect would be astounding. A few years ago John Bogle wrote an article on indexuniverse.com. In the article he stated that an investment of $10,000 in the S&P 500 at its 1926 inception, with all dividends reinvested, would by the end of September of 2007 have grown to over $33,000,000. That’s 10.4% compounded. If dividends had not been reinvested the value of the investment would have been about $1,200,000 (6.1% compounded). Over those 81 years, the reinvested dividends accounted for roughly 95% of the compounded return.

With dividends providing a nice share of the total return, it might be beneficial at this point to review the topic of dividend investing. Terms such as payout ratio, dividend yield, and dividend yield on cost should be understood by investors of all levels. For the longer term investor, yield on cost provides an increasingly potent kicker to stock returns.

Let’s look at these three fundamental measurements using some real data from Johnson and Johnson, a long term core holding in the In Sickness and Wealth personal portfolio.

Dividend Yield

= current annual dividends per share/current stock price
Payout ratio = current annual dividend per share/current annual earnings per share
Dividend Yield on Cost = current annual dividend per share/stock price at original purchase

With JNJ the current annual dividend payment per share is 3.00 (paid out in $0.75 installments each quarter). JNJ’s current price is about $100 a share. Hence its dividend yield is: $3.00/100 or 3.0%. How does a 3.0% dividend yield compare to the overall market? The S&P 500 as a whole currently has a dividend yield of about 2.0%; just under the 10-year Treasury Note yield. There are stocks that yield north of 10%, and some that have a no dividend policy. Most investor’s would prefer to be paid dividends—one notable exception being Warren Buffett’s Berkshire Hathaway. If you had to choose between Buffet reinvesting earnings or paying you a dividend for you to invest, which one would you choose? Now you know why Berkshire does not pay a dividend.

A long consecutive string of dividend payments is one of the better indicators of financial strength and competitive position. Without a track record of solid earnings and free cash flow, it’s tough to pay out dividends. One of the best ways to gauge the longer term health of a company is the number of years they have been paying dividends. An even better way is how many consecutive years they have been raising their payout. At the end of this article, we list a few of the healthcare companies with stellar dividend histories. As you will see, they are dominant companies with extraordinary business franchises.

One thing to be mindful of is stocks that pay too high a dividend yield. About a year ago a deepwater drilling company by the name of Seadrill boasted a dividend over 9% (its stock was trading around $40 a share). Seadrill made ultra deepwater drilling rigs that rented out for $575,000 per day. But with a 9% yield, one couldn’t help but question its sustainability and if earnings/cash flow would indeed cover the payout. One of the best indicators of dividend stability and sustainability is the payout ratio.

Let’s look at JNJ again. Its annual earnings per share stand at about $6.10. Payout ratio is the dividend divided by the earnings per share or: $3.00/$6.10—about 48%. The payout ratio is paramount when it comes to dividend investing. For the S&P 500, the payout ratio is about 37%. A hair over one third of earnings go to paying dividends. Whatever earnings don’t go to investors in the form of a dividend, remains for the company to reinvest in the business. Seadrill’s payout ratio was almost 100%. In other words, if Seadrill’s earnings were to suffer even slightly, they would not be able to cover the dividend payout. As everyone knows, the price of oil was cut by 60%, rig rentals crashed, earnings suffered and the payout wasn’t just cut – it was eliminated entirely. The yield of dreams turned into a total return nightmare as Seadrill’s stock crashed from $40 to $6 a share in about a year. One has to be vigilant when searching for good dividend-paying stocks. Some exceptionally strong companies can afford to stretch the payout ratios into the 60 or 70% zone (utilities, many of which have monopoly positions, are one example of companies with higher payout ratios). Personally, I like to see the payout ratio under 50% if possible but will bend for a stable company with a long history of paying dividends. There are some companies that have paid dividends consistently for over 50 years—some even longer. If a company in question has a 100 year history (there are a few!) of paying dividends but has a payout ratio exceeding 50 percent, I’d give it a look. As long as the cash flow and other vital fundamentals such as debt load and return, and return on equities are strong, it’s still worth considering. JNJ’s is under 50% and it’s been paid without interruption for decades—in sickness and health!

The next topic is relevant to longer term investors and it’s referred to as dividend yield on cost. To calculate dividend yield on cost, we take the current annual dividend payout and divide by the investor’s original purchase price. For JNJ this would be: $3.00 per share/$10.6 dollars per share (my original cost) which comes out to a 28.2% yield on cost—hence the title of this article—Yield of Dreams! I have held JNJ for 22 years. Each year they have raised their dividend. In fact, JNJ has increased its dividend each year for the past 53 years! As investors hold on long enough, usually dividends will increase relative to your original purchase price. When the yield on cost gets this high, every three to four years your dividends pay for the original cost of your shares.

Legendary investor T Rowe Price was one of the great beneficiaries of the yield on cost phenomenon. He used to buy growth stocks and hold for decades. His first purchase of Minnesota Mining and Manufacturing (3M) was made in 1939 at a split adjusted price of $0.50 per share (the dividend at purchase was $0.025 per share for a handsome 5% yield). However, by 1978 the dividends grew to $2.00 a share. Hence his dividend yield on cost grew to 400%; each quarter’s dividends actually paid the cost of his original shares. Several of his long term holdings went on to achieve dividend yields on cost exceeding 100 percent.

A long history of dividend payouts, in particular increasing dividend payouts, carries enormous weight with investors. Coca Cola, Proctor and Gamble and a few others have paid uninterrupted dividends for over a century and have rewarded investors richly. But the business franchise, strategic position, debt load and competitive position are also critical for long term investment success. When you think about the global reach, strong branding, and sheer size of Johnson and Johnson, Abbott Labs, Walgreens and others, these are dividend champions one should consider (In fact, the ISAW portfolio owns many of them). I think even the most anxiety ridden investor might sleep better owning some of these great business franchises. Figure 1 and 2 below provide some historical perspective and statistics on the topics of dividend yield and payout ratios.

Figure 1: Perspectives on Dividends
Highest dividend yield of S&P 500: 13.84% (June 1932, at height of depression)
Lowest dividend yield of S&P 500:

1.1% (August 2000, right before tech bubble burst)
Average dividend yield of S&P 500: 4.40% (Average since 1930)
Current dividend yield of S&P 500: 2.03%
Dividend yield of S&P 500 Healthcare sector: 1.7% (as of October 2015)
Highest payout ratio of S&P 500 since 1930: 90.10% (during depression, 1930s)
Lowest payout ratio of S&P 500 since 1930: 32.3% (2000-2010)
Average payout ratio of S&P 500 since 1930: 54.3%
Payout ratio of S&P 500 Healthcare sector: 28% (as of October 2015)
Figure 2: Healthcare Stocks with the Longest Consecutive History of Dividend Increases
Johnson and Johnson 53 years
C.R. Bard 44 years
Becton Dickenson 44 years
Abbott Labs/Abbvie 43 years
Walgreens Boots Alliance 40 years
Sigma Aldrich 40 years
Medtronic 38 years
Cardinal Health 30 years
Ecolab 30 years

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