Rising interest rates may pose headwinds to yield-sensitive dividend payers, but we think dividend growth investing remains a resilient theme. We’re big fans of the concept of yield-on-cost, but close attention to valuations, free cash flow generation and balance-sheet health will remain critical.
By Brian Nelson CFA
We’re big fans of dividend growth investing. Identifying strong businesses that generate considerable free cash flow and have healthy balance sheets to cushion against their growing dividends is one of the key themes of the Dividend Growth Newsletter and its simulated portfolio. The concept of yield-on-cost is a very important one, too, and something that any dividend growth investor should be aware of. Scooping up a dividend-paying company that has a juicy dividend yield, but one that is also poised to grow considerably over time, only increases the yield on original cost.
Simulated newsletter portfolio idea Realty Income (O) is a great example of yield-on-cost, dividend growth investing. The company was listed on the NYSE in 1994, and since then has increased its dividend 97 times, with 83 consecutive quarterly dividend increases, translating into a compound average annual dividend growth rate of ~4.7%. Here is the key point regarding the concept of yield on cost: In 1994, Realty Income’s annualized dividends were $0.90 per share, and the company ended 1994 at ~$8.50 per share, good enough for a solid ~10% dividend yield at the time. But let’s say, you bought shares of Realty Income in 1994. The REIT’s dividend now stands at $2.64 on an annualized basis. At your hypothetical original cost of ~$8.50 per share, today’s current annual dividend rate now implies a yield-on-cost of over 30% ($2.64/$8.50).
The yield-on-cost dynamic is one of the key reasons why dividend growth investing is so appealing. If you can find a reasonably priced equity that has strong free-cash-flow generation and a solid balance sheet to keep upping the dividends in the decades ahead, the capital put in place today could generate a huge yield-on-cost in coming years. Realty Income is a big success story, and we don’t want to say such a strategy is not without considerable risk, but the concept of yield-on-cost is sound, in our view. Dividend growth investing holds great promise, but rising rates will always pose a risk to capital preservation, something that we think is inescapable. Let’s explain further.
Though, for example, Realty Income’s equity advanced considerably during the past few decades, it did so in a declining interest-rate environment. REITs, of course, can handle rising rates by advancing funds from operations (FFO) at a more-than-offsetting pace to mitigate valuation impacts, but falling rates have been a boon to dividend payers. Not only were REITs generating gobs of FFO to up their payouts during the past few decades, but the market’s appetite for risk only increased during this time, as evidenced by falling interest rates/borrowing costs (and concurrent higher stock prices). Realty Income yields ~4.9% at the time of this writing, and the risk to the capital of long-term dividend growth investors rests in a market that might yet again demand a 10% yield on REIT assets, similar to what it did during the mid-1990s, for example.
As simple math implies, if the market demands a hypothetical doubling of current yields on equities, as the market did just a few decades ago, it would suggest pressure on the prices of many high-yield equity prices, all else equal. REITs and other high-yielding entities, of course, may be able to keep generating improved free cash flow and increasing their dividends in coming decades to offset such a rising-rate headwind, but rising interest rates in any respect, pose a headwind, by itself. No member of Valuentum should have been surprised by the negative impact of rising rates on higher-yielding assets such as master limited partnerships (AMLP) and consumer-staples stocks (XLP) thus far in 2018. As interest rates rise, equity prices for yield-sensitive equities tend to react inversely, all else equal, and we want to make sure that you’re aware of this dynamic, and what might be ahead.
From where we stand, the yield-on-cost concept makes dividend growth investing a resilient theme over the long haul, however–and overlaying this thematic strategy with a key focus on valuation (price-to-fair value) and assessments of future free cash flow generation (cash flow from operations less all capital spending) and balance-sheet health (cash less debt) are ways to guard against potentially exogenous price shocks that could impair capital. What we’re trying to say is that it’s not only important to focus on the potential for dividend growth, but you should also be evaluating the Dividend Cushion ratios of entities and understand what is implied by adjusted and unadjusted Dividend Cushion ratios, the former an assessment of dividend health during good credit conditions and the latter an assessment of dividend health during poor credit conditions. Not every company can survive if the credit markets shut down, for example.
Overall, we continue to be pleased with how well ideas in the simulated Dividend Growth Newsletter portfolio have been performing, and we believe the efficacy of the Dividend Cushion ratio may make it one of the most helpful forward-looking metrics in any dividend growth investor’s tool kit. The Dividend Cushion ratio can be found in each company’s dividend report on the website, and the measure forms the basis for many of the dividend growth and safety metrics we assign. Don’t forget to make use of the vast resources on the website, as the newsletters are but a small part of the work we do. Thank you!
<This is the intro of the July 2018 Dividend Growth Newsletter. Access the Dividend Growth Newsletter archives here.>
REITs – Healthcare: HCP, HR, LTC, OHI, UHT, VTR, WELL
REITs – Retail: CONE, COR, DDR, DLR, FRT, GGP, KIM, MAC, O, REG, RPAI, SKT, SLG, SPG, SRC, TCO, WPC
Related: VNQ, SCHH, IYR, ICF, RWR
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.