We’ve never been more concerned about the financial health of dividend growth investors. Perhaps we’re partly to blame for some of the excitement surrounding the strategy that has taken many corners of the web by storm, but we continue to believe it is important for investors to strive to understand the strategy’s fundamental fallacies, which can’t be talked about enough as a means of helping investors understand key risks.
For those new to dividend growth investing, part of the strategy centers on identifying stocks that pay dividends that are poised to increase over the long haul, generating in time a yield (a payout) that is a) sufficient on the cost and b) sufficient to generate an adequate income in retirement years. This article cannot possibly capture all of the various ways investors may be using an equity-based income growth strategy, but we think for several, the common tenets below are worth emphasizing.
An informed investor is a better investor.
1. The Dividend Is Not A Driver Behind Stock Returns
As we continue to evaluate several studies on dividend growth investing and aggregate data for our white paper on the topic, to be published in coming months, one thing is clear: definitionally, earnings and free cash flow must be the primary drivers behind equity price performance. Though there are many examples that help explain this, we think one example is perhaps only needed to remember the spuriousness of the dividend to total returns.
What some investors may not remember is that in the mid-1990s, Apple (AAPL) completely eliminated its dividend, and the iPhone giant only recently reestablished the payout earlier this decade. Steve Jobs’ masterpiece has been one of the best performing stocks in the history of equity investing, and it’s simply difficult for us to ignore that the company eliminated its dividend in the past. Such a truism may not help investors that already understand that future earnings and free cash flow are what drives the equity valuation framework (and equity prices), but we think the example may be helpful to others as to why dividends are said to be a symptom (an output) of strong companies and their valuation paradigms—not a driver behind them.
In our view, it is misleading to say that Apple’s strong stock performance beginning earlier last decade was the direct result of the firm reinstituting a dividend nearly a decade later after the fact. By extension, we think it is equally misleading to say that any company’s strong returns over the past several decades have been a direct result of their dividend policies. The dividend growth investment framework may be suffering from one of the biggest statistically fallacies in investing history: Correlation does not imply causation. Said differently, it is more appropriate to say, in our view, that the strong performance of dividend payers has been (and/or should be) a direct result of expectations of continued strong earnings and free cash flows, not from a steadily-increasing dividend.
The elimination and re-initiation of a payout has been irrelevant to Apple’s total returns since its inception, as much as the absence of a dividend has been to Berkshire Hathaway’s (BRK.A) (BRK.B) total returns during the past many decades.
2. You Already Own Everything That a Company Will Ever Pay You as Future Dividends
A stock is a claim on a company’s assets, including net cash on the balance sheet, and all of the future earnings and free cash flows associated with such assets. Said differently, shareholders already own today, via the stock price (its intrinsic value), anything that a company will ever pay out as dividends in the future.
The very idea that a company will generate earnings and free cash flows in the future, for example, is why a company has any value at all today, and dividends are generally paid out as a portion of earnings and free cash flow. The payout of a dividend in this light is not an incremental value-driver to a company’s business; the dividend, as a portion of future earnings and free cash flow, is already captured in the value equation.
Valuation is and will always be independent of the dividend. Let’s explain this in personal-finance terms.
Many investors would agree that an individual already owns the cash in his/her personal savings account, much like a shareholder already owns the net cash in a company’s savings account, better known as its balance sheet. If you were to make a withdrawal from your personal savings account, paying yourself in cash what you already own, you are not more or less wealthy because you have done so. You are merely transferring funds from your bank account to yourself, converting the savings to cash in hand.
This dynamic is similar to what happens when companies pay a dividend to shareholders. Certainly from a conceptual standpoint, most corporates pay out dividends as a portion of earnings and traditional free cash flows, but from a financial standpoint, an entity will always pay a dividend from cash on the balance sheet. To understand why this must be true, one has to look no further than the business models of REITs and MLPs, which consistently pay out dividends/distributions at a level significantly greater than their respective earnings and traditional free cash flows in any given period. Without external capital-market assistance (i.e. the financing section of the cash flow statement), which flows directly to cash on the balance sheet, the lofty dividends and distributions of REITs and MLPs, respectively, wouldn’t be sustainable.
Net cash on the balance sheet is something investors already own, and such cash is already captured within the valuation framework, which is reflected in the price that shareholders have already paid for an ownership piece in the company (stock). Much like taking cash from your savings doesn’t generate value/wealth to you, a company paying a dividend to shareholders doesn’t (shouldn’t) generate value/wealth to you either, generally and in most cases.
3. The Total Return of a Company Is Not Bolstered By Dividend Policies
Investors tend to think of a stock’s total return as a function of both its capital appreciation and dividend yield. For example, some investors think that, because a company raises its dividend, that the total return of the stock would be augmented. This is generally not true.
When a company pays a dividend, it is actually reducing the cash (or would-be cash) on its balance sheet, thereby reducing the intrinsic worth of the company relative to a situation where it instead would have stored such cash on the balance sheet. All else equal, a company that has $1 billion in net cash on the balance sheet is worth more than a company that has a net debt position. A dividend payment, in reducing balance sheet cash and therefore in reducing the price of the equity, also a) reduces the capital appreciation component of total return as it b) increases the dividend component of total return at the same time.
A company is not creating more total return by paying a dividend; it is merely shifting a portion of total return from one component to the other, in most cases.
4. Artificial Valuation Paradigms Surrounding Dividends Have Put Dividend Growth Investors at Serious Risk
The one major and unsettling caveat to the view that a dividend payment does not augment total return is why we’re particularly worried about dividend growth investors in the coming rising interest rate environment.
The intrinsic value of an entity will always be a function of what it generates as earnings and traditional free cash flows to shareholders–and dividends, being a part of such future streams, will only represent a portion of such a value. In no cases should a company be worth more than what it can generate in future earnings and free cash flows to shareholders on an organic basis.
However, in the case of most MLPs, such business models–by paying distributions that are significantly greater than earnings and free cash flows–are subject to an unsustainable valuation (pricing) paradigm that is being propped up by external financing endeavors. In such cases, because the valuation paradigm centers more on an artificial and financial-engineered dividend payout–one that is greater than organically-derived future earnings and free cash flows–such companies’ total return dynamics are being fueled by inorganic dividend policies. Such policies inflate both the capital appreciation and dividend components of shares/units, where the dividend/distribution actually starts to drive capital appreciation–and the higher stock prices then help fuel the dividend in a self-reinforcing bubble (often infused via debt issuance).
Once this artificial valuation paradigm inevitably pops, however, as in what might happen with ongoing contractionary monetary policy or in the case of falling energy-resource prices with respect to most energy MLPs, the total return component for such entities should collapse, in our view. Definitionally, under no case can an entity sustainable pay out more than it generates organically in earnings and free cash flow, without continuous assistance from the external capital markets, which cannot be guaranteed over the long haul. Dividend growth investors are absorbing a tremendous amount of risk heading into a tightening credit environment by investing in companies that pay inorganic dividends. This is our greatest concern with entities that fit the profile of a Kinder Morgan (KMI)–a good and stable business has become a risky and unstable one in light of risk-seeking financing activities.
5 High-Yielding Strong Dividend Growth Stocks for the Long Haul
With all of this said, there is nothing wrong with focusing on underpriced, strong companies with solid, cash-rich business models that pay strong and growing dividends, provided that such dividends are generated organically and backed by healthy balance sheets and future streams of free cash flow. Here are five of our favorites that fit such a profile.
Apple (AAPL) – Fair Value: $142
What a great example to use to disprove the importance of dividends to total returns, yet it is perhaps one of the strongest dividend payers in the market. With the billions of cash on the balance sheet and the billions it generates in cash flow from operations coupled with the minimal capital outlays, it’s just hard to find another company whose dividend is healthier. Investors are focusing on China as a potential headwind to growth, but we think investors are already discounting such an impact as it relates to Apple. At nearly half the market multiple, we continue to view shares as a bargain. The company yields ~1.8%.
Cisco (CSCO) – Fair Value: $36
The communications networking giant may have finally thrown off its association with the dot-com bubble in the late 1990s. Not only does the company have a very healthy balance sheet, but it is simply not getting credit for its earnings stream. Annualizing its quarterly non-GAAP earnings per share of $0.59 during its fiscal fourth period means shares are trading at ~12 times run-rate earnings with a significant net cash position to boot. Big tech has become the land of dividend health, and Cisco is no exception. The company yields ~3%.
Johnson & Johnson (JNJ) – Fair Value: $108
Like most multinationals, J&J is experiencing currency headwinds, but we like its fundamental performance. We’re particular fans of the company’s pharmaceutical portfolio, with it having already launched 7 products in the past five years that are expected to generate over $1 billion in annual sales by the end of 2015, but the outlook may be even better. Its robust pipeline includes more than 10 new molecular entities (NMEs) that are expected to be filed by 2019 and may have similar promise. The company has a nice net cash balance to back future free cash flows against an ever-higher payout. Shares yield ~3%.
Microsoft (MSFT) – Fair Value: $56
The software giant may be our top dividend growth idea, perhaps neck-and-neck with Apple. Not only has Microsoft turned the corner with respect to fundamental momentum and investor perception, but its balance sheet remains flush with net cash that, like the others on this list, can be used to support an ever-increasing payout that’s already covered with future organic free cash flows. The launch of Windows 10 may provide a short-term boost to results, and we expect innovation under CEO Sayya Nadella to flourish. Shares yield ~2.8%.
Visa (V) – Fair Value: $75
The credit-card payment processing giant is an under-the-radar dividend growth giant in that its yield isn’t yet high enough to catch income investors’ attention. However, with an operating margin in the mid-60% range, it’s hard not to like the company’s difficult-to-replicate network effect, which only grows stronger as plastic use proliferates. The company’s balance sheet and free cash flow generation may turn heads, but its dividend yield might not, however. At less than 1%, it’s not one for current income, but long-term dividend growth investors could wake up one morning on the announcement Visa has tripled, quadrupled, or even quintupled its dividend.