Dividend payers deserve a berth in any long-term stock portfolio, but seemingly attractive dividend yields are not always as fetching as they may appear. Let's take a look at the pharmaceutical industry, in order to find its most promising dividends.
First, though, understand just why you should want to own dividend payers. It's because they can contribute a huge chunk of growth to your portfolio, and they can bolster it during market downturns. My colleague Matt Koppenheffer has noted, "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."
Yields and growth rates and payout ratios, oh my!
When hunting for promising dividend payers, the unsophisticated investor will often just look for the highest yields he or she can find. It's true that they'll pay out the most, but that's just for this year. Extremely steep dividend yields can be shaky, and even solid ones can be vulnerable to dividend cuts. When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors -- its current yield, dividend growth rate, and payout ratio.
If a company has a middling dividend yield but a history of increasing its payment substantially from year to year, it deserves extra consideration from you. A $3 dividend can become a $7.80 one in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.
Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. It can be spent growing the business, paying off debt, buying back shares, or even buying another company. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.
Peering into pharmaceuticals
Below are the major players in the pharmaceutical industry (and a few smaller outfits). I've ranked them according to their dividend yields.
5-Year Avg. Annual Div. Growth Rate
|Johnson & Johnson||3.5%||10.0%||42%|
Source: Motley Fool CAPS.
If you focus on dividend yield alone, you might end up with Eli Lilly and GlaxoSmithKline, but they're not necessarily your best bets. Their dividend growth rates aren't stellar, and GlaxoSmithKline's payout ratio is a little steep.
Instead, let's focus on the dividend growth rate first, where sanofi-aventis and Meridian Bioscience lead the way. Their growth rates are so steep, though, that they may be hard to maintain for long. And the fact that their payout ratios exceed 100% is also a red flag.
Novo Nordisk and Teva Pharmaceutical have both strong growth rates and low payout ratios, making them rather attractive. But their yields are on the low side. That's not necessarily a deal-breaker, but the ideal stock would have a higher yield as well.
Fortunately, a handful of companies satisfy on all three counts: AstraZeneca, Johnson & Johnson, and Abbott Labs. They sport substantial yields above 3%, good dividend growth rates, and reasonable payout ratios. They all offer some solid income now and a good chance of strong dividend growth in the future.
You're doing your portfolio a disservice if you're ignoring the growth you can get from powerful dividend payers.