I've often described dividend stocks as the heart and soul of nearly every successful retirement-focused portfolio. Unfortunately, I've also come to terms with the idea that the golden age of dividends is officially dead.
What's behind a dividend payment
Dividends serve multiple purposes for investors. The most obvious is that they provide shareholders with extra cash that they can either pocket to boost their immediate income or reinvest with the intent of compounding their gains (and dividends) over the long term.
Dividends are also a great hedge against a volatile or downtrending market. Dividend payments can help offset losses experienced when stocks simply follow the market lower in the short term. A 2% or 3% yield is unlikely to pull your portfolio back into the black during a recession, but any hedge to offset short-term losses is bound to calm an investor's nerves and help take emotions out of the equation.
Lastly, dividends signal to investors that a company's business model is sustainable and able to stand the test of time. A long history of payments and/or dividend increases only further solidifies the image of a quality dividend-paying company to investors.
The death of the golden age of dividend investing
For the Silent Generation and baby boomers, a healthy dividend payment was the expectation. Historic dividend payout ratios (the percentage of profits paid out in the form of a dividend) between 1923 and the mid-1990s regularly hovered between 40% and 65% for S&P 500 companies. Understandably, there have been fluctuations in these payout percentages, as recessions can lead to periods in which payouts are artificially high as corporate profits rapidly fall. During the Great Depression and Great Recession, for example, payouts ratios crossed 125% and 90%, respectively.
But since the mid-1990s, investors have witnessed a new norm: an average dividend payout ratio for S&P 500 companies near 30%.
This isn't to say corporations aren't looking out for their shareholders. In fact, according to Bloomberg, the cumulative profit return to shareholders (share repurchases plus dividends) was an estimated 95%, or $914 billion, in 2014. But it's becoming increasingly clear that corporations are focusing more on share buybacks rather than dividends.
Bloomberg forecasts that S&P 500 companies will spend $565 billion on share buybacks this year, with another $349 billion going to dividend payments. This compares to projected profits (as of estimates in October) of $964 billion. Cumulatively, this works out to a payout ratio of 36%. Meanwhile, FactSet pegs the S&P 500's cumulative trailing payout over the previous 12-month period at just 32%.
Corporate America's fascination with buybacks
Why the overwhelming love for share buybacks? Share buybacks help reduce the number of outstanding shares, making for a more favorable EPS calculation. In other words, a higher EPS figure could help push the price of a company higher because it makes the stock look cheaper on a price-to-earnings basis, boosting shareholder value.
But shareholder buybacks also come with an inherent flaw: They can cover up weak growth. Rapidly growing companies are often reinvesting every cent they generate in cash flow back into their business. It's usually when a company matures, or its growth slows down, that it begins offering a dividend or repurchasing shares. A company that's aggressively buying back shares can, with cost-cutting, dramatically boost its EPS despite falling sales. Although this can be a recipe for short-term share price appreciation, it's a dangerous smoke-and-mirrors game that can mask a lack of genuine growth.
Right now, there are more than enough examples to illustrate this point.
Take big-box retailer Best Buy (NYSE:BBY), which has spent around $8 billion in share buybacks since 2004 even as its share price lost about a third of its value over that same time span. Over the trailing-12-month period Best Buy managed to deliver $2.85 in EPS on net income of $1 billion. However, it delivered practically identical full-year EPS in 2007, though it earned nearly $1.4 billion in net income that year.
Are we as investors to believe Best Buy now is performing on par with 2007? Even a surface-scratching dive would uncover the obstacles that have held Best Buy back, including showrooming -- when consumers shop around in physical stores for items they later buy online for a lower price. Yet Best Buy's share buybacks have resulted in enough of an earnings boost that the share price has held up phenomenally well. The sad thing is those share buybacks could have paid off Best Buy's $1.6 billion in debt five times over or potentially added up to $1.20 per share each year in extra dividend payouts.
Need another example? How about information technology behemoth IBM (NYSE:IBM). Over the past decade IBM has reduced its outstanding share count by a little more than 700 million to 991 million shares. The $12.7 billion in net income and $97.4 billion in sales it has delivered over the trailing-12-month period netted IBM investors $12.34 in EPS. Yet in 2008, IBM produced close to $104 billion in sales and $12.3 billion in net income but didn't even crack $9 in EPS. In sum, sales are down 6% since 2008, but the share price is up around 25% because of the buyback-induced EPS bump.
I don't want to misguide you by suggesting there's absolutely no value in share buybacks, because that would be blatantly wrong. Corporations can also be investors, and when the time is right, buying back shares of their own stock to reward long-term investors can be a smart move. But I'd suggest few companies are paying any heed to value these days. Rather, they're merely boosting buybacks in order to give the impression of growth.
One place where you can still find quality dividend stocks
Finding quality dividend stocks is becoming tougher for income investors still accustomed to the golden age of dividend investing. However, there's one group of dividend stocks you can still count on: the Dividend Aristocrats.
Dividend Aristocrats, of which there are more than 50 to choose from, are companies that have raised their dividends for a minimum of 25 consecutive years. Some have even breached the 50-year mark. Such a long history of payout increases proves the company's willingness to share its profits with shareholders and all but ensures that an above-average level of profits are paid out to investors relative to the S&P 500's average payout ratio.
What will you find among the Dividend Aristocrats? Primarily, this elite group is made up of basic-needs goods and service stocks, such as healthcare conglomerate Johnson & Johnson (NYSE:JNJ), whose personal care products, medical devices, and pharmaceutical goods enjoy consistent demand. Diseases and disorders aren't cyclical, and neither is J&J's profitability.
You'll also find strong brand names among Dividend Aristocrats, such as Coca-Cola (NYSE:KO), which operates in all but two countries worldwide and has logo recognition of better than 90% around the world. Products that can sell themselves based on brand name and recognition are often good bets for solid dividend growth over time.
I'm not ruling out the idea that there could one day be another golden age of dividend-paying stocks, but for now, the reality is that investing for income just isn't as easy as it once was.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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