The Dividends of Understanding Dividends

It's Dividend Week on Industry Focus!

On this episode, Motley Fool's Gaby Lapera and senior banking specialist John Maxfield explain what dividend stocks are, how to pick them, and how to make the most of them in your investment strategy. Tune in, as John Maxfield also shares the names of a few reliable, well-performing dividend stocks.  

A full transcript follows the video.

Gaby Lapera: Hello everyone, welcome to Industry Focus, financials edition! We thought we'd change up the show and do a theme week in conjunction with the other sectors, so get excited for Dividend Week Industry Focus! Tune in to each of our episodes this week to hear what the other IF contributors think about dividends in their different sectors.

So, I'm just gonna dive right into it. We thought since this was the first show of the week, we would do a quick little, "What is a dividend stock? Three things you should look for in a dividend stock". Maxfield, what is a dividend stock?

John Maxfield: A lot of investors would probably be like, why are you guys covering such a basic thing? Well, the important thing to realize is not everybody is at the same level of investing. So, when you're talking about dividend stocks in particular -- there's a couple different kinds of stocks. There's growth stocks like Tesla, companies like 3D Systems, companies that are quickly growing. And then there are income stocks that aren't growing as quickly, they're more mature. But what they do, as opposed to taking the money they earn and reinvesting that into the business, they distribute that money to shareholders each quarter via dividends. So, you could buy a stock for $100 and get $2 in dividends each year. So, that's what dividend stocks are.

Lapera: Right. I just want to point out that just because companies are paying out dividends, doesn't necessarily mean that they're not investing in themselves. There's three things you want to look out for when you look at dividend stocks: the dividend yield, the payout ratio, and the growth ratio. The payout ratio tells you how much of a company's earnings are paid out as dividends. This is going to be expressed as a percentage. Generally, you want them to be below 100.  If it's 100, that's like DEFCON 1, because that means they're paying out more than they make in dividends. And that's not good for anyone, because you need that money.

Maxfield: Let's break each of these metrics down. If you're a dividend investor, and you're out looking for a great dividend stock, there are three metrics that you start with. The first of the dividend yield. That is the annual dividend distribution divided by the share price. Let's say you buy a stock that's $100 per share. It pays $2 a year in dividends, so, $0.50 per quarter in dividends. That means 2/100 would be 2%, so that's the dividend yield. All else equal, a higher dividend yield is better for income investors than a lower dividend yield. 

But there are exceptions to this, and Gaby just mentioned one. So, the second metric you want to look at is the dividend payout ratio. The question is, the dividend payout ratio, to Gaby's point, what it does is it is a percent and it expresses the percent of a company's earnings that it distributes to shareholders via dividends. Now, as a general rule, you want to see this in the 30, 40, 50% range, because that means that not only is it a sustainable dividend, so even if a company's earnings go down a little bit, it'll still be able to support its dividend; but also because it shows that there will be an opportunity for dividend growth.

Lapera: Of course, certain companies are legally required to pay more dividends. The classic example are REITs, which are real estate investment trusts.

Maxfield: Exactly. So, the size of that payout ratio -- what is and is not an appropriate payout ratio -- isn't set across companies. So, you have mortgage REITs, other types of REITs, other types of companies that, in order to get tax treatment, so you have [...], so you're not taxed as a corporate entity, you're just taxed at the investor entity -- in order to qualify for that, in many instances, for these specific types of companies, they have to distribute at least 90% of their taxable income. So, you're going to have company is that just pay out a lot of money.

And then, the other thing to keep in mind is that you also have companies like AT&T and Verizon. These companies pay out a huge portion of their earnings to shareholders, sometimes even exceeding 100%. But what's important to take into consideration with telecom stocks and other stocks like that is, when you have companies that have a ton of depreciation from massive capital investments, that will decrease your net income, but you'll still have a lot of cash flow to fund your dividends. So, in that situation -- and this is more of a nuanced technique -- you want to look at a dividend payout ratio that uses not the net income as the denominator, but rather a company's free cash flow. So, that's that second piece of the dividend payout ratio.

The third piece that Gaby brought up is looking at--

Lapera: It's the growth rate, by the way.

Maxfield: Exactly.

Lapera: Just in case people got lost in the explanation of dividend yield and payout ratio, we're talking about the growth rate now.

Maxfield: I don't know if there's anything you wanted to talk about before I chimed in with my own two cents on that, or ... ?

Lapera: No, you go ahead.

Maxfield: Basically -- and this is really basic -- when you buy a stock, you want your investment to grow over time. That's why you buy stocks, for that compound annual growth rate over time. So, you apply that same philosophy to your dividend. You look at companies and say, "Look, if I buy a share today for $100 that's paying out $2 per year dividends. Let's say their earnings are growing at a 10% clip, and they're gonna grow their dividend along with that, so maintain their payout ratio -- what is that dividend gonna look like in 10 years? Maybe it'll be $10 per share." So you want to keep that in mind.

The best way you can really gauge that is looking at the company's history of dividend increases. If their executives have proven that they are committed to returning capital to shareholders, that should come through in the numbers over time, and it probably should project into the future.

Lapera: Yeah. I do want to say one thing about the growth rate -- every once in a while, you'll have a company drop their dividend ratio, and that can happen for a number of reasons. One, maybe the company is in trouble. But two, maybe the company is expanding, and they need that extra money to buy whatever other company they're going to buy, or to invest in themselves. So, a company dropping its dividend ratio isn't necessarily a time to panic. You just have to do your research and figure out exactly why they're dropping it.

Maxfield: That's exactly right. As a general rule, you should assume it's bad when a company decreases or eliminates its dividend. As a general rule. However, there are certainly many exceptions to that, and the only way you'll know in any particular situation, when a company that you're invested in drops its dividend, whether or not that falls under the general rule or the exception is, to Gaby's point, to really dig into the details of the explanation behind that drop or elimination of a dividend.

Lapera: So, I'm sure you're all asking yourselves now, "What role should dividend stocks play in my portfolio?" Because that's what everyone's thinking right now. Our more experienced investors probably know that as you get older, you're probably going to want to shift your portfolio focus to more steady stocks. That typically means stocks with dividends. Those companies are established; they can afford to pay out the dividends. These are the type of people we call "income investors".

Maxfield: Right. And if you think about the arc of a life of an investor, when you're young and just starting to invest, you're gonna want to look for things that will benefit you over many, many decades, and have the opportunity to compound at a fast rate over many decades. These are your growth stocks.

On the other side of the ark, you're approaching retirement, you're going to stop working, you're going to go into your golden years. So, what you're gonna need there is something to pick up and to take the place of your foregone income. And that's where things like Social Security come in, your 401K, things like that. But dividend stocks play a central role in that, because they provide that income that you'll be looking for in retirement.

So, when you're thinking about dividend stocks, there's two things to take in mind. First, they replace that income for you going into retirement. The second thing is that, as a general rule, dividend stocks tend to be more mature and stable businesses, and therefore more stable additions to your portfolio, so when you're in retirement, it's not gonna be going all over the place and making you worried about whether or not you're gonna be able to cover your bills for the next year.

Lapera: I know that you said that you had a good dividend stock that you wanted to share with our listeners, something that they should consider adding to their portfolio.

Maxfield: Yeah. When you think about good dividend stocks, really, what you're thinking about are the best companies that you can invest in, because you're talking about tapping into an earnings stream. And even more importantly, tapping into a growing earnings stream. So, you need a company that is stable, that you believe their earnings will grow, and that their executives have demonstrated a commitment to returning some of that capital to shareholders via dividends. 

So, when I think of companies like that -- and people who listen to this show regularly know that I'm a bank analyst, so I really focus on the banking and financial sector -- so when I think of companies, I'm thinking of the greatest banks. So, I'm thinking about your Wells Fargos and your US Bancorps, your JP Morgan Chases. All three of those banks have reasonable payout ratios, in the roughly 30% range. All three of those banks have proven themselves through multiple decades, multiple credit cycles, that they can generate earnings consistently. All three of those banks have proven that their earnings grow consistently over time, as they take over market share of their less well-run competitors.

So, you have all of those things factoring into this huge and growing income stream that is pushing out the shareholders. So, when I'm thinking about a great dividend stock in the banking sector, which is what I cover, those are the three companies that come immediately to mind.

Lapera: Right. So, we're gonna talk a little bit about REITs now, because REITs are the other big financial stock that pays out dividends. Like we mentioned before, they're required by law to pay out 90% of their income in dividends. Specifically, we're gonna be talking about mortgage REITs, which we'll refer to as mREITs for the rest of the show, because mortgage REITs is a little bit of a mouthful.

Mortgage REITs buy mortgage-backed securities. Do you want to talk about this?

Maxfield: Yeah. REIT is an acronym for real estate investment trust. Real estate investment trusts are trusts -- a legal entity -- that owns real estate-related assets. Well, Congress, multiple decades ago, sat back and said, "Look, if we want to encourage investment into real estate and things like that, let's have these trusts set up in a way that people can put money into them, and that whatever money is earned from those will not be taxed at the corporate level, as long as at least 90% of the taxable income automatically flows through to their shareholders via dividends." That's where that high payout ratio that we talked about earlier comes in.

Mortgage REITs are a very specific type of a real estate investment trust, because, as opposed to buying into real estate assets themselves -- actually buying land or building -- they buy mortgage-backed securities. More specifically, as a general rule, agency mortgage-backed securities. So, these are issued by Fannie May or Freddie Mac, and they're backed by the full faith and credit of the United States government. So they're basically the same as buying Treasury certificates.

What mortgage REITs do is, they will go out and borrow a whole bunch of money in the short term credit markets -- so, your repo markets, your commercial paper markets, stuff like that, where interest rates are really low -- and then, they'll invest that money into agency mortgage-backed securities, where the interest rates are higher. And their profit on the spread between the cost of funds and what they're yielding on their assets. So, that's how mortgage REITs make money and are able to have, at least historically, have had such large dividends throughout the years.

Lapera: I just want to put out a quick disclaimer before we go forward. mREITs have made a lot of people money in the last 10 years, but the wise investor is really gonna want to take a good, long, hard look at any kind of mREIT before buying stock. It's already kind of a chancy area to invest in, because you're betting on the spread of interest rates. And sometimes, mREITs' business practices are not always on the up and up. Specifically, you're definitely going to want to look at any mREIT that's buying mortgage-backed securities that are not agency-secured. That's just super, super risky.

John Maxfield: Yeah. I'd be a little more nuanced on that latter warning. What I would say is this: in my opinion, the mortgage REIT trade -- and we've had a number of companies that really focused in mortgage REITs, as opposed to being a real estate investment trust that focuses in mortgage REITs as just one component, and other types of real estate. For the pure mortgage REITs, that trade, that investment, it does not look to be very optimistic going forward, and there are two reasons for that.

The first: if you go back to the early 1980s, when we had rapid inflation, the Federal Reserve brought interest rates way, way up to slow down that inflation. So they brought them up into the 18-20% range, even for really short-term rates. Ever since then, interest rates have been going down. One of the consequences of falling interest rates is that on the other side of that, the value of fixed-income investments -- which mortgage-backed securities are -- the value of those increases as interest rates go down. So, you have, let's say, Annaly Capital Management (NYSE: NLY) or American Capital Agency, you have these companies that are sitting on tens of billions of dollars of mortgage-backed securities, i.e. fixed-income securities, as these interest rates have been coming down. So, those values have just consistently been going up over the years.

Well, interest rates are now plateauing around the 0% rate. So you can't look at a mortgage REIT's past and look into the future and think: "That's what the business will look like in the future," because we just aren't going to see the short-term interest rates go up 20% any time soon. It's hard to envision a scenario under which that would be the case. So, you're going to have that benefit coming away from the mortgage REIT.

The other benefit that you have coming away from the mortgage REIT is, where they really, really made a ton of money over the past couple decades -- and they've done well over the past couple decades, but where they really killed it was during the financial crisis when the Federal Reserve dropped interest rates to near 0% relatively quickly, but the longer-term interest rates took longer to adjust downwards. So, that spread was really wide for a time period. And that's why a company like Annaly Capital Management was so popular and did so well during the financial crisis.

Well, now, again, you have interest rates -- both long and short-term -- compressed right about 0%. So you're just not gonna have the size of the spread. It was literally a once-in-multiple-generations type of thing that made mortgage REITs so profitable over the past couple decades. That, in my opinion, is now gone.

Gaby Lapera: Absolutely. I don't know if listeners out there are wondering with the long-term interest rates are set. Those follow the short-term interest rates, it just takes some longer to adjust, because they are, obviously, long-term. So, say, you bought a house pre-financial crisis. You probably had a mortgage with a pretty high right. That's why a lot of people ended up having to default during the financial crisis.

Now, that has evened out. You can buy a house with significantly lower interest rates on your loans now than you could before.

Maxfield: Yeah. Anybody who's thinking about buying a house, keep this in perspective: over the last 30 years, the average interest rate on a conventional 30-year mortgage has been something like 8.5%. I don't know exactly what it is right now, but it's something like 3.8%.

Lapera: Yeah, it's super low.

Maxfield: You're looking at historically low interest rates. And then, when you factor in that eventually, you'll have some inflation come back into the equation, so that'll work against that. Let's say we get 2% inflation, and you're paying 3.8% on your mortgage. You're basically paying 1.8% to borrow money. It's just ridiculously cheap right now.

Lapera: Yeah. We should probably talk a little about what mREITs will do in the future. The one that comes to mind is Annaly Capital. They were kind of the first, and still the biggest mREIT out there. But what you're saying that they're doing, in order to cushion themselves for what they know will probably be a lean season for them, is they're starting to move over into commercial real estate.

Maxfield: Right. So, this is the dominant player in the industry, that a couple years ago, has started to diversify away from that pure mortgage REIT business model that did so well for it for so long. If that shouldn't be a sign for investors, then I don't know what is.

Lapera: Yeah. It's kind of how, in the tech industry, when Apple does something, everyone kind of looks to it and says, "You know, maybe we should start thinking about doing that, too."

Maxfield: Yeah. And let me be clear: there are a lot of people who go around and think that Annaly Capital's management is so brilliant because they've done so well over the decades. I have a tendency to think that they were just in the right place at the right time, it was more luck than anything else, is what's behind their success. That being said, they are the industry leader. So, if you want to divine the future of the industry and the trends we're going to see going forward, Annaly is certainly at the cutting edge.

Lapera: Absolutely. That's pretty much all the time we have. Before we wrap up, I want to let everyone know that as part of dividend week, we've put up a free web page that has a selection of dividend stocks that the contributors of Industry Focus are interested in. It is at dividends.fool.com, so go take a look. Again, that's dividends.fool.com. I was told to really annunciate the word dividends, with an S, so I hope y'all got that.

Anyway, thanks for joining us, I hope that you liked this week's episode. Write to us at [email protected] to let us know what you think or send us cat pictures. As usual, people on the program may have interest in the stocks they talk about and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks very much and we'll see you all next week!