Dividend-Paying Stocks Continue To Garner Attention

We continue to be confounded by this trend, especially with the yield on 10-year U.S. Treasuries hovering around 1.85%, and the 30-year bond yielding a little less than 3.10%. With the Fed making the decision this past week to buy up large volumes of mortgage-backed securities while keeping borrowing rates low for an undetermined period of time (which basically means until the job market and the broader economy have started to show signs of improving on their own), we don't see much potential for these returns to improve much in the near to medium term. At this point, even the S&P 500 Index, which is currently yielding a little more than 1.90%, could be viewed as being somewhat more attractive, given that bond prices are going to fall once interest rates do finally start to rise. In our view, finding stocks that are yielding more than the benchmark index, but that operate in stable industries, where there is bound to be less uncertainty about their future cash flows, is likely to offer some downside protection for investors. After all, a healthy and safe dividend yield should offer some solace in the midst of market volatility like we've seen over the last four-plus years, and relative to fixed income, dividend-paying stocks have the potential to produce both higher yields and long-term capital gains for investors.

Top 10 Dividend-Yielding Stocks of Our Ultimate Stock-Pickers

Stock Price and Morningstar Rating data as of 09/14/12. *Dividends for American Depository Receipts (ADRs) can be impacted by changes in currency exchange rates. Our calculations also adjust for special dividends.

While just four of the 22 mutual fund managers on our current list of Ultimate Stock-Pickers-- Amana Trust Income(AMANX),  Columbia Dividend Income(LBSAX),  Oakmark Equity & Income(OAKBX), and  Parnassus Equity Income(PRBLX)--focus almost exclusively on income investing, there are plenty of managers that look to include dividend-paying stocks in their portfolios. As such, we typically generate a list of more than 500 different holdings that are producing a yield for our top managers each time that we run the data. In order to hone in on higher-quality names, which are held with a greater degree of conviction by our top managers, we narrow this list down to include only stocks that are held by at least five of our Ultimate Stock-Pickers, with yields greater than the S&P 500 Index, representative of firms with wide or narrow economic moats, and where our stock analysts have an uncertainty rating of either low or medium on their fair value estimates. We think that by focusing on wide- and narrow-moat firms we should be able to highlight firms with competitive advantages that should allow them to generate the cash flows they'll need to maintain their dividends longer term. And by only considering firms with low or medium uncertainty ratings, we are narrowing our list down to firms where our analysts have a greater degree of conviction behind their fair value estimates. It should also be noted that our dividend yield calculations are based on regular dividends that have been declared over the last year and do not include the impact of any special (or supplemental) dividends.

With very little changing in the list of top 10 dividend-yielding stocks of our Ultimate Stock-Pickers since the last time we reported on them, we thought we'd focus this time around on the current attractiveness of dividend-paying stocks, given that there are relatively few stocks in the top 10 (let alone the top 25) dividend-yielding stocks that are in the portfolios of our top managers trading at a deep enough discount to our analysts' fair value estimates to warrant further investigation. We were prompted to look more closely at this subject not only by the lack of attractive opportunities within the top dividend-yielding holdings of our Ultimate Stock-Pickers, but by the comments made by Bill Nygren in his quarterly commentary for the  Oakmark(OAKMX) and  Oakmark Select Funds(OAKLX), which cautioned investors about the "alleged safety of high-yield stocks" in the current market environment, noting that:

"Mike Goldstein of Empirical Research Partners has a graph showing that, over the past 60 years, the 100 highest yielding stocks in the S&P 500 have on average sold at about three-quarters of the S&P 500 P/E multiple. The high yielders are typically more mature, slower growth businesses that deserve to sell at a discount P/E. Effectively, a high yield (D/P) is just the inverse of a low price-to-dividend ratio (P/D), a cheapness measure similar to a low price-to-earnings or low price-to-book ratio. Historically, high-yield stocks have been cheap stocks.

Today's high-yield stocks are quite a different story. The 100 highest yielders in the S&P 500 have a much higher yield than the index--4.10% vs. 2.50%. The S&P 500 today sells at 12.9 times expected 2012 earnings. If the high yielders sold at their 60-year average discount, they would be priced at less than 10 times earnings. Instead, today's top 100 yielding stocks sell at 13.9 times expected earnings, more than a 40% relative premium to their historic average. The only reason they yield more than the rest of the S&P is that they pay out so much more of their income--57% vs. 32%.

Another statistic courtesy of Mike Goldstein is that utility stocks, a high-yield group I call the most bond-like of all stocks, today sell for almost the same P/E multiple as the S&P 500. Since 1970, their average P/E multiple has been about two-thirds of the S&P, and 90% of the time utility stocks have sold at a larger discount than they do today. We believe that investors who are now stretching to get more income from their equity investments are making the same mistake as bond investors--they are ignoring valuation and instead have a misplaced prejudice that high yields will protect them against loss."

Given the strength of Nygren's conviction on this matter, we thought we'd turn to Josh Peters, Morningstar's resident expert on dividends for some insight into the current environment for dividend-paying stocks, as well as to get his thoughts on the comments coming from one of our Ultimate Stock-Pickers. For those not familiar with Peters, he is the driving force behind Morningstar DividendInvestor, a monthly newsletter dedicated to traditional equity-income investing, and is the author of "The Ultimate Dividend Playbook: Income, Insight and Independence for Today's Investor." Our conversation with Peters went as follows:

We have seen some commentary recently on the relative valuation of high-yielding stocks. Specifically, Oakmark's Bill Nygren has written that high-yield shares are "more likely to be fully priced." What are your general thoughts on valuation in the high-yield stock universe?

I agree that high-yielding stocks--those paying 3.00% and up--are more or less fairly valued. There are some areas of overvaluation--regulated utilities, REITs, telecoms and the tobacco stocks come to mind. These companies aren't likely to surprise to the upside in a better economic environment, but their valuations could be hurt if and when faster economic growth is accompanied by higher interest rates. But there are also pockets of opportunity. Lately I've bought  Public Service Enterprise Group(PEG) at a 4.00%-plus yield, which has a merchant generation business that will benefit from higher power prices in a better economic environment, and 5.00%-yielding  People's United Financial(PBCT), a bank with gobs of excess capital for growth and an asset/liability mix that becomes more profitable with higher interest rates. I also like  General Mills(GIS) and  Chevron(CVX); a lot more low-3.00% yielders are trading at respectable valuations than the group of stocks paying over 4.00%, and you usually get much better dividend growth and prospective total returns to boot.

At the same time, I don't think that the low/no-yield sector of the market represents a superior opportunity. Using Morningstar's fair value estimates for our entire coverage universe, there's very little skew in fundamental valuations that can be traced to dividend yields. Low interest rates have certainly driven some money into high-yielding stocks that might otherwise be in the bond market, and there's still plenty of nervousness when the topic turns to the global economy. However, I believe that the low P/E ratios in the tech sector, to name one example, suggest that investors are rightly skeptical about capital allocation practices. A dollar of earnings that is paid out by  Southern Company(SO) as a dividend is worth a dollar, but a dollar of earnings retained by  Microsoft(MSFT) is probably worth less than 100 cents when you look where most of the cash goes. So much corporate cash flow gets wasted on acquisitions and dubious share buybacks as inferior substitutes for dividends that I think discounted valuations are appropriate and likely to persist until capital allocation practices improve.

Very interesting. Since you brought up share repurchases, another thought-provoking point brought up by Nygren is that he sees many investors as biased against stock buybacks, stating that a stock buyback can have a similar result--or even better because of tax issues--as a dividend payout used to purchase more shares. What are your thoughts on the merits of buybacks versus dividends?

I don't mind share repurchases as a supplement to an appropriately generous dividend, but buybacks are a poor substitute for dividends. Setting aside the tax issue for a moment, it is true that a buyback has the same theoretical effect as an investor's decision to reinvest his or her dividends. But not all investors want to reinvest their dividends, and even those who do reinvest shouldn't be forced to reinvest the equivalent of dividend back into the company paying it. Dividends give individual shareholders much greater flexibility--consistent cash returns to meet financial obligations, or funds for reinvestment that the shareholder controls.

Of course, there's also the practical reality of share buybacks: Most companies buy back shares when they've got excess cash, which often coincides with market peaks and high valuations. When buybacks would create the most shareholder value--at the bottom of a cycle--the spending almost always stops. Look at  Dell(DELL), which bought back $21 billion of stock between 2004 and 2008. Not only did management wildly overpay for its shares when you consider where Dell trades today, but it cut its buyback expenditures to zero in 2009. Some firms even wind up reissuing shares previously bought back at much lower prices--you'll find abundant examples of this phenomenon in the banking sector. As I said earlier, a dollar paid as a dividend is always worth a dollar, but a buyback could be worth more or less--and given the tendency of management to overvalue their own shares, the value of a buyback is often much less.

I can't dispute the point that the tax code still favors buybacks over dividends because the tax associated with unrealized capital gains can be deferred indefinitely, even in taxable accounts. It makes sense that Warren Buffett prefers that  IBM(IBM) spends so much more on buybacks than dividends: Despite his age, he's still very much in wealth-accumulation mode, and Berkshire's structure guarantees that IBM's earnings will be taxed not twice but three times (once on IBM itself, again at the Berkshire level, and then on Berkshire shareholders). But most investors eventually transition from accumulation into a "harvesting" mode that requires them to make regular withdrawals from their portfolios. They're going to pay taxes no matter what. Dividends allow investors to collect consistent cash returns without being forced to sell shares at low prices during market downturns; as we all know, capital gains come and go.

In any event, I don't think it's the job of a company's management or board to minimize the theoretical tax liability of shareholders, who have other tools to manage their tax circumstances. After all, Enron and WorldCom did an awesome job of minimizing their shareholders' taxes in the end.

Great. You touched on taxes a little bit. What is your view on possible tax law changes and their impact on the appeal of dividend-paying companies?

Tax policy is and should be relevant to all investors, but the appeal of dividends goes far beyond today's tax rates, and I think the issue is very important to understand thoroughly before reacting to what is inevitably an emotional topic. Let's start with where we are now. Current law taxes both dividends and long-term capital gains at a maximum federal rate of 15%, which has been the case since 2003, but this law is set to expire soon. Assuming nothing changes, dividends will be taxed as ordinary income (up to 39.6%) starting Jan. 1, 2013, with long-term capital gains being taxed at half the ordinary rate (up to 19.8%). A new health-care-related tax on investment income for high-earners will tack on another 3.8 percentage points to both rates. But however hard it is to have any faith in Congress, I doubt even they will let the country roll off the "fiscal cliff" on January 1. My best guess is that we get another short-term extension of some kind.

Then, hopefully, we will move on to the arduous process of tax reform. Here, the key feature to watch will be any gap between the rates on dividends and long-term capital gains. Both types of investment returns share the same source--corporate profits--but historically dividends have been taxed as ordinary income, while capital gains have benefited from far lower maximum rates. In the early 1960s, for example, the top marginal tax rate was an astonishing 91% (though it didn't kick in until the equivalent of $3 million or $4 million of annual income in today's dollars), but the long-term capital gains tax was capped at 25%. There is a decent chance that another tax bracket or two--maybe 20% or 25%--will be applied to investment income for high earners. But as long as the rates remain the same for both dividends and long-term capital gains, this shouldn't distort the markets. The main threat is that we go back to the bad old days where capital gains got a break and dividends didn't, but on three separate occasions (2003, 2008, and 2010) different congresses and presidents have affirmed the principle that capital gains and dividends should be taxed equally.

But let's assume the worst: that long-term capital gains taxes go up a little, but dividend taxes go up a lot. The impact from there is highly individualized. Despite the way the media usually reports on the topic, most investors aren't in the top tax bracket--their tax rates on dividends might go from 15% to 25% or 28%, but 39.6% won't apply across the board. Many Americans also own the bulk of their stocks--and collect the bulk of their dividends--in tax-deferred accounts like IRAs, Roth IRAs, and 401(k) plans. In these accounts, the tax rate on dividends (or capital gains) doesn't matter because taxes are paid only on account withdrawals, which have been taxed as ordinary income all along. While we're at it, the payouts of real estate investment trusts (REITs) and master limited partnerships (MLPs) weren't eligible for the 15% rate in the first place, so they don't have that to lose.

Finally, then there's the thorny question of "what's the alternative?" Someone who is absolutely determined to avoid paying a higher tax rate on dividends won't have many choices. He could try to reorient his portfolio for more long-term capital gains, but capital gains are very tough to live on--just when you need to make a withdrawal, the market falls apart and you're selling more shares than you expected, and at a loss to boot. The consistency of dividends--always and only positive, never needing to be given back--is a tough feature to beat. Of course, there's also the bond market, but the interest on bonds (except municipals) has been taxed as ordinary income all along. Does a 10-year Treasury paying less than 2.00% and offering no protection from inflation become a viable alternative just because the taxes on dividends have gone up? Dividends, unlike bond interest, do have a track record of responding to inflation to protect the purchasing power of the investor's income stream. I understand that a reduced tax rate on dividends helped revive their appeal in 2003, but according to a study by the Federal Reserve, the effect was short-lived. Demographics (aging baby boomers) and dissatisfaction (volatile equities with little forward progress, super-low interest rates) have a lot more to do with the current appeal of dividends than tax rates.

Can we turn now to some specific stocks? You touched on this earlier, but could you discuss some dividend payers you like these days?

Sure--I actually like talking about individual businesses a lot more than the macro environment, though it does help when my favorite companies fit in well with a reasonably conservative big-picture view. I've never bought a stock because of a specific economic or interest-rate forecast, but I do avoid stocks whose dividend-paying capacity could be hurt by a recession.

My favorite stock right now is Chevron, which I mentioned earlier and yields 3.10%. That might not sound like a lot, but it's a solid income return when you consider that the dividend has risen an average of 10% a year over the past decade, and that Chevron's dividend has grown every year since 1988. That streak of growth covers a pretty wide range of oil-price swings, and that's by design: With oil prices being very high, the company is paying out less than 30% of its earnings, so it can absorb a significant downturn without threatening the dividend or even continued hikes. Though all of the major private oil companies face challenges just replacing reserves, Chevron is disproportionately rich in (scarce) oil and underweight in (abundant) natural gas compared with its peers. And despite spending huge sums on new exploration and project development, excess cash is piling up at a furious rate. This could lead to faster dividend growth, a one-time special payout, or perhaps a major acquisition, but the company's track record suggests that management can be trusted to deploy capital in a way that optimizes both current dividend income and long-term sustainability and growth.

I'm also a big fan of General Mills, a stock that tends not to be cheap, but represents a reasonably good value right now. The stock yields 3.40%, but this is actually relatively high based on the stock's history (and makes for a sharp contrast to regulated utilities, where current yields are at generational lows.) The franchise itself is wonderful, with brand names like Cheerios that would cost incredible sums to replicate. It also helps that people need to eat, so it's hardly a surprise that most staples firms turn out pretty consistent cash flows. As with Chevron, though, I admire management's approach to capital allocation. About half of earnings go out to shareholders as dividends, a smaller share goes to buybacks, and the rest gets divvied up between internal growth (which doesn't cost much, thanks to very high returns on tangible capital) and bolt-on acquisitions. In a slow-growth industry like food--after all, people will only eat so much--it takes both operational excellence and prudent capital allocation to turn 1% population growth into high-single-digit dividend increases, but that's the model General Mills has been executing successfully for years.

Most of the stocks I regard as buys right now have yields between 3.00% and 4.00%. The 4.00%-and-up crowd, though certainly appealing on the basis of income, are generally overvalued when you consider their lower long-term dividend growth rates. (Always, always, always focus on total return!) Still, I like  Royal Dutch Shell(RDS.B) at a 4.70% yield. Shell isn't quite as appealing as Chevron, and its dividend probably won't grow nearly as fast, but it should beat inflation by a percentage point or two.

Public Service Enterprise Group, which yields 4.50%, is my only utility pick right now. In addition to its regulated operations in New Jersey, which has become a pretty good state in terms of regulation, PSEG operates some low-cost, well-positioned nuclear power plants out east. However, with merchant power prices being depressed by a weak economy and rock-bottom natural gas prices, current earnings are somewhat depressed. Since 2009, PSEG's stock price is basically flat, while Southern is up a good 45%. To me, though, this signals that investors haven't inflated PSEG's valuation just because interest rates are low and low-risk assets are in favor. To me, that's kind of a risk for Southern--after all, the economy is bound to improve someday, and when it does, interest rates will go up. Fortunately, PSEG's earnings should benefit a lot more from a stronger economy than Southern's or most other fully regulated utilities, and until that happens I'm actually picking up a current yield that is higher than the fully regulated average along with dividend growth that should at least match the low-single-digit average for the regulated firms.

What don't you like in this environment?

Valuation is a concern for some areas of the high-yield equity market, but the number-one risk to dividend investors is always the threat of a dividend cut. You've got to be skeptical and even a little paranoid. Take  Frontier Communications(FTR), for example. In early 2011, with the dividend rate at $0.75 a share annually, the stock sold near $10. To me, the dividend wasn't obviously at risk--Frontier was generating a lot of cash--but I certainly didn't see any growth on the horizon, and the most logical move in either direction seemed to be down. In early 2012, the dividend was cut to $0.40. That's an awful hit, but worse yet is the fact that the stock had lost half its early-2011 value before the dividend cut was announced.

Prime candidates for dividend cuts right now are  Pitney Bowes(PBI), yielding 10.20%, and  R.R. Donnelly(RRD), yielding 8.80%. Pitney's once-great core business of postage meters is in secular decline, and if anything management has made the situation worse by taking on a big debt load in an effort to diversify the business. Donnelly is a major commercial printer, another business that is probably in secular decline. It's also got a lot of debt, and plenty of cyclical downside in recessions. Both companies have preserved their dividends so far, and Pitney has even managed to keep a dividend growth streak alive with some tiny hikes in the past few years. Given the states of these businesses, shareholders are probably better off receiving the biggest dividends the companies can manage. But the market is clearly signaling major threats to these dividends within a few years, and I don't want to be part of the picture if and when the ax finally falls.  Avon Products(AVP), yielding 5.90%, is another mess I wouldn't want to touch, and I avoid all specialty financials like Annaly Capital Management (NLY) like the plague no matter how high their yields are. Here's a good rule of thumb: If it does bank-like things but isn't technically a bank, it could have speculative merit--but don't bank on the dividend.

On the valuation count, I'd be worried if I owned REITs like  Kimco Realty(KIM) and  ProLogis(PLD). I don't think their dividends are at risk of being cut, but in any kind of a normalized interest-rate environment, a sub-4.00% yield on a REIT could look pretty ridiculous in hindsight. Same goes for a few regulated utilities like  Piedmont Natural Gas (PNY) and  American Water Works(AWK). There's nothing necessarily wrong with the businesses--I actually think Piedmont is one of the best utilities around--but there really isn't enough long-term growth in these business models to generate decent total returns when the starting yields are so low. At least Piedmont is paying 3.70%, but American Water Works yields only 2.70%!

Fortunately, I don't think dividends are in a "bubble," as some pundits have claimed. After the last 12-13 years, a lot of people have become prone to spot bubbles around every corner. I actually have trouble imagining just what a dividend bubble would look like. If a stock becomes popular because it yields 4% and the price were to quickly double, the yield drops to 2.00%. But long before that happens, the yield will cease to be an attraction. Some other factor could take over and the stock could keep rising, but it won't be the yield. Instead, most of the usual dividend-paying candidates yielding more than 4.00% are in a range between fairly valued and perhaps 10%-20% overvalued--not enough that I would bolt for cash. Even that level of overvaluation makes a certain amount of sense if you assume interest rates stay this low for another 3-4 years; it's not as if you can sell, go to a money market fund, and earn 5.00% while you wait for rates to rise. (You'd be lucky to earn 0.05%.) However, that's not an assumption I'm willing to make when committing new money to stocks--I tend to let high-quality winners like  Altria Group(MO) and  Magellan Midstream Partners ((MMP) ) run a bit, but I always look for a margin of safety when buying.

How does the lack of clarity in the current economic and investing environment play into the appeal of dividend-paying companies? For instance, Columbia Dividend Income Fund's recent commentary has stated that "large-cap, high-quality, dividend-paying stocks should outperform in an uncertain environment."

The short-term appeal isn't too hard to understand. If the economy remains stuck in low-growth mode, or dips back into recession, then the kinds of companies that generally pay good dividends--consumer staples, utilities, Big Pharma, and so on--should continue to perform reasonably well--probably outperforming the market averages that include more cyclical stocks. But uncertainty necessarily cuts both ways: The range of potential outcomes for the economy and the market also include unexpected upturns, and these companies don't have much to gain in terms of earnings and dividend growth. In a brisk economic recovery, or whenever the market goes on a short-term speculative binge, it would be only fair to expect these stocks to underperform.

That said, I don't think there's any point in trying to time shifts in market sentiment. The outlook is always uncertain; the main thing that changes is the market's perception of uncertainty and the corresponding effects on valuation. Institutional money will often shift from high-beta stocks to low-beta ones when the outlook darkens, though usually not until prices have already made such a swap a value-neutral proposition at best.

For individual investors, I think the appeal of dividends is not about "what's the economy going to do?" or "where's the market going?", but "what do I need to accomplish with my portfolio?" If you need income today, or expect to need income in the future, it only makes sense to build your portfolio around large, reliable, and growing dividends through all market environments. The long-term appeal of dividends won't be so much a cyclical factor as millions of additional investors figuring this formula out.

In general, what can we expect as far as dividend payout increases from companies going forward? Will dividend boosts generally perform in line with the economy? Any sectors/companies likely to underperform or outperform, or even deviate from this trend?

I think the increased awareness of--and desire for--good dividends is encouraging corporate America to meet the demand, but there's still a long way to go. From 1946 through 1994, the dividend payout ratio of the S&P 500 Index was 50%-55%. Today, a near-record-low 30% of profits are paid out as dividends, which explains why the market's current yield is so low by historic standards. That suggests the potential for a lot of companies with low payout ratios or no dividends at all to get with the program, but I'm not sure the stocks with the most room for improvement are actually the best bet.  Apple(AAPL),  Cisco Systems(CSCO), and Dell have recently joined the ranks of dividend-payers, but they should have been paying good dividends for years, and even now they're still paying well below their potential. If you buy a stock because you think it will pay a dividend, or turn a small one into a big one, you could be in for a long, unrewarding wait. I tried it once, with Microsoft, which illustrates my point. Since 2005 the dividend has gone from $0.08 a share each quarter to $0.20, but the stock price has barely budged. I don't know how much enduring credit the market will give to remedial dividend actions like Microsoft's or Cisco's, but it probably won't be much.

Of course, those companies that already pay good and appropriately sized dividends don't have as much room to grow. In the mature dividend-paying sectors--energy, staples, health care, utilities, and industrials--companies like  Johnson & Johnson(JNJ),  Spectra Energy(SE), and  Procter & Gamble(PG) will probably go on raising their dividends in line with per-share earnings growth. But that's not at all bad when you consider their 3.00%-4.00% yields compared with a 10-year Treasury under 2.00% or the wish-and-hope game of owning a non-payer like  Google(GOOG). The only other group I'd mention is the banks, where dividend increases have been held back by regulatory diktat. I hope that starts to relax in 2013 and payout ratios can break the 30% barrier, but if it doesn't, the bank dividend recovery will probably have run its course a lot sooner than people expected.