Here at the Fool, we're prone to saying that debt is really bad for you and for companies in your portfolio. Well, so is an all-burger diet. But the occasional chili cheese patty from Sonic (yummy) won't put you in the hospital. Think of debt in the same way: It adds flavor in moderation.
Hold the mayo?
But it might not feel that way if you're an income investor. After all, firms with big debt loads are at risk of cutting or eliminating dividends if trouble arises. That's why the rule of thumb says to stay away from companies that have feasted on credit like Fat Albert at Dairy Queen.
But rules are made to be broken, and the so-called rule against debt is no exception. Here's why: Heavy borrowers can make for wonderful investments, so long as the cost to get capital is more than offset by the earnings created by putting the newfound moola to work to fund growth, a measurement otherwise known as return on capital (ROC).
Pour it on
To illustrate my point I went looking for stocks that paid hefty dividends but also had substantial debt loads. The catch was that each firm had to earn a high return on equity (ROE), and its debt had to be less than 50% of stockholders' equity, which roughly equals what owners could expect if the firm were liquidated. Here's the complete list of screening criteria:
- Total debt equal to 50% or less of total stockholders' equity.
- A dividend yield between 3% and 7%.
- Dividend per share growth of at least 5% annually over the past three years
- Operating cash flow (OCF) growth of at least 5% annually over the past three years.
- ROE of at least 10%.
- A market cap of at least $500 million, and trading on at least one of the major U.S. stock exchanges (i.e., New York, American, or Nasdaq).
Which companies came up? Have a look:
|
Company |
D/E* |
Yield |
Div./ |
OCF/ |
ROE |
|---|---|---|---|---|---|
|
Alliance- |
0.0% |
4.7% |
11.7% |
6.5% |
18.6% |
|
Chevron |
20.5% |
3.1% |
7.7% |
26.5% |
26.1% |
|
Commerce Group |
22.9% |
3.4% |
6.1% |
11.0% |
20.1% |
|
LTC Properties |
19.9% |
6.3% |
47.7% |
14.0% |
11.3% |
|
Mercury General |
8.9% |
3.5% |
12.8% |
12.7% |
16.5% |
|
Nam Tai |
3.9% |
6.7% |
102.1% |
21.5% |
16.7% |
|
Pfizer |
27.3% |
3.7% |
13.5% |
13.1% |
12.1% |
*Debt to Equity.
This would have made for an impressive portfolio over the past three years. And your risk would have been spread among a diverse group of dividend-paying stocks, covering everything from the energy sector to health care and pharmaceuticals to electronics.
Why didn't debt matter in these cases? Efficiency. It's no accident that companies that earn very high returns on capital can service their debt and fund a growing dividend.
The Foolish bottom line
When looking for dividend-payers, don't simply screen out debt. You'll end up missing out on some very promising industries and companies. Instead, make sure you focus on sustained dividend growth funded by gains in cash flow, as well as high ROC. Those are a few of the traits chief analyst Mathew Emmert looks for in his Motley Fool Income Investor portfolio, and his picks are beating the market by more than 3 percentage points as of this writing. (And that's before an average dividend yield in excess of 4%.) Click here to see his recommendations and analysis free. There is no obligation to subscribe.
Fool contributor Tim Beyers is all for kicking it up a notch, especially when it comes to his portfolio returns. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in Tim's portfolio by checking his Fool profile. AllianceBernstein (formerly Alliance Capital) and Mercury General are Income Investor picks, and Pfizer is a Motley Fool Inside Value recommendation. The Motley Fool has an ironclad disclosure policy.
