Continuing with our dividend-week theme, our energy team takes a deeper dive into why it's so much more difficult for energy and materials companies to maintain dividends, and what investors should look for in a dividend stock that deals in commodities. To find out our picks for the top dividend stocks in 2016, check out dividends.fool.com

A full transcript follows the video.

 

This podcast was recorded on 11/19/2015.

Sean O'Reilly: We're going shopping for energy and materials dividends... on this energy edition of Industry Focus.

Greetings Fools. I am Sean O'Reilly here in studio at Fool headquarters in Alexandria, Virginia. It is Thursday, November 19 and this week is dividend week on Industry Focus.

Tyler Crowe: Hey!

O'Reilly: Yay!

Taylor Muckerman: Hey!

O'Reilly: Joining me and whose sultry voices you just heard are Tyler Crowe and Taylor Muckerman. What's the good word, boys?

Crowe: Well, we were just talking about a whole lot of Carolina Panthers.

Muckerman: A whole lot of Carolina Panthers.

O'Reilly: I was about to say, is it their year?

Crowe: Ask Taylor. He's the Carolina Panthers fan.

O'Reilly: Is this it?

Muckerman: It could be. Rematch of 2003.

O'Reilly: It's good to be a big cat I think is the trend I've seen.

Muckerman: Well, yeah. So the, well, the Bengals are out. So just the Panthers and apparently the Cheetahs are still left.

O'Reilly: Who would've thought?

Muckerman: The Cheetahs.

O'Reilly: Who would've thought?

Muckerman: It was a little .gif I saw the other day.

O'Reilly: Yeah, you'll have to send that to me.

Muckerman: New England Cheetahs.

O'Reilly: Cheetahs. Cute.

Muckerman: Oh, that's what I saw. Whatever.

O'Reilly: Oh my God did you see how the Patriots won over the weekend?

Muckerman: Yes. I hated it. We need to be the best team for once.

O'Reilly: I know. I just, I feel bad for Eli and just the whole...

Muckerman: Whatever.

O'Reilly: I don't know.

Crowe: My dad's a Giants fan. He was not a happy man, not a happy man.

O'Reilly: With four TVs broken?

Crowe: No his oldest thing is...

Muckerman: It's not the Super Bowl. But it was a rematch.

Crowe: It's always his thing is when the Giants aren't playing well, he goes out and cleans the garage. The garage was spotless after last Sunday. Spotless.

O'Reilly: Beautiful. It was swept, the shelves were organized... everything.

Crowe: Oh yeah, beautiful.

O'Reilly: Awesome. So moving on to the energy sector and dividends -- other shows so far this week have highlighted American brands like Johnson & Johnson, Philip Morris -- storied American brands that we all know are just going to pay tons of dividends, and cash flow, and all kinds of good stuff.

We have a little bit tougher of a job because our sector's not doing so hot right now. And it is extremely cyclical. In your opinion, what's the biggest challenge to investing in energy and materials for income?

Crowe: Well, I think what you just said there is a really important thing that energy and materials just doesn't have like you said, Johnson & Johnson, Philip Morris, Coca-Cola -- storied brands. They have that ability to brand, and with brand comes pricing power and that is an extremely powerful thing. You can just be like, "Oh, we're going to raise Starbucks. We're going to raise it $0.50." And nobody says a word about it.

O'Reilly: Which they do.

Crowe: And they do routinely. You can do that with cigarettes, you can do that with a bottle of Coca Cola. Unfortunately, get me...

O'Reilly: ExxonMobil (NYSE:XOM) crude, I only want ExxonMobil crude.

Crowe: There is no such thing as branded product in the energy material space. It is a commodity and you know you could say that somebody like an ExxonMobil has a recognizable name. But it doesn't mean that what they do is going to generate a premium simply because of that. And without that pricing power -- and like you said, we're much more subjected to commodity prices in energy and materials -- it makes it that much harder to get that routine day in, day out, increasing revenue, increasing profits, increasing dividends.

O'Reilly: Any thoughts?

Crowe: I think that's pretty much it.

Muckerman: That was it?

Crowe: Yeah, it's tough.

O'Reilly: Want to keep talking about the Panthers?

Crowe: Oh, we could, they're winning.

O'Reilly: No, we need to give the people what they ask for. That being said, is it possible for anybody in the energy materials space to... I mean, we all know kind of the answer because there are some energy/materials names on the Dividend Aristocrats list that we'll talk about later. But is it just about cost-cutting? What does it take to make it to a Dividend Aristocrat status as an energy and material name? Is it just about cost-cutting? Is it about vertical integration, which we were also talking about before we went on air?

Muckerman: I mean, yeah: prudence, foresight, consistency.

Crowe: Crystal balls.

Muckerman: Well, somewhat. I mean, some companies do have better insight because they have a larger customer base, they're involved in greater geographic regions, so that diversity is there. Some people are more integrated, so you have companies that have refining and they have upstream so they're a little bit more balanced there. But yeah, I just think prudence when times are good and it gives you some more flexibility when times are like they are right now. And there really aren't that many names on the Dividend Aristocrat list, and like you said, we'll talk about it later, but they're mostly utilities, which is a fairly stable industry.

For now, who knows the disruption that solar and wind power and renewable energy will cause. But for the last 100 years or however long we've really been relying on coal and natural gas power, and steam power, and everything, utilities have been the only real consistent dividend payers in the energy industry.

Crowe: And surprisingly, they haven't done as great as I think so many people say.

Muckerman: Right. I think it's one of those just old tales.

O'Reilly: Well, it's regulated. Regulators try to basically guarantee a certain growth on capital.

Muckerman: And at one point they were able to grow, but the population of the U.S. has kind of stabilized, we're not in need of so many new power plants as we were back in the '40s, '50s, '60s when the baby boom was coming on. And now all those folks are old, they're living in their houses, they have kids, but they're having kids at a lesser rate. Even our generation now is having kids at a lesser rate than that. So you're seeing population...

Crowe: Throw in energy efficiency and you're looking at flat to 1% electricity growth. And if you even look at what you called the storied names in utilities -- you think of somebody like a Southern Company, a Duke Energy, somebody like that -- they've cut their dividends actually multiple times in the past 10-15 years.

O'Reilly: Did they do any... because Taylor was talking about prudence and during good times and everything. Did they overreach, get into natural gas when it was 13 bucks?

Crowe: Well, these projects take forever to build, so sometimes you just, it's not overreaching when it takes place. But if five people have a nuclear power plant or a big coal plant coming online in the next five years and they all come on that line at once, they're like, "Well, we didn't really expect that to happen."

O'Reilly: Oops.

Crowe: So much for that one.

Muckerman: Yeah, had one or two of them come online, sure, they'd be sitting pretty. But everybody wants a piece of that.

Crowe: Which is exactly what we see across so many other energy and materials. I mean we could talk about the commodities boom of 2011 where everybody... let's talk about iron just for a second. Iron ore. Over the past three or four years, companies like BHP Billiton, Rio Tinto, things like that, plowing money into new mines. And all of a sudden they're all coming online now, at we could say an inopportune time in terms of demand. But at the same time bringing that much on at the same time -- oops, too much.

O'Reilly: Game over.

Muckerman: And you have the strong dollar, so it impacts a lot of these emerging markets where these metals are coming from. And oil is priced in the U.S. dollar, so it's more expensive internationally now. So yeah, it's just a...

O'Reilly: So are energy investors just out of luck when it comes to dividends? What should we be avoiding these days? What do we need to avoid -- something we can kind of narrow down?

Crowe: Cash flow, free cash flow. You want to see consistent, positive cash flow there. So that kind of takes into account...

O'Reilly: For a decade? Like what are we...

Muckerman: I mean, yeah, a decade will smooth out maybe a cycle or so, but when you're on an upturn, generally I just look at the near term. Because they darn better be able to pay their cash flows then and there. Because this is the best time to be able to have cash flows.

In the downtimes, that's when I would lengthen out the time frame a little bit because hopefully this bear market in oil isn't going to last forever. So if you just look at the last year, cash flows have just been destroyed. So you expect that to turn around. So maybe look out to see how they've done the last two, maybe three, maybe five years, so that way you can get a better picture of what they've been able to do.

But in the markets where things are soaring like Tyler said, 2011-2010, if they're not handling their business in the last one or two years, they're probably not going to handle it when the cycle turns south.

O'Reilly: Cool. Before we move on, and going along with this week's income focus theme, I wanted to point our listeners to a special article written by five Industry Focus contributors detailing their top picks for dividend stocks. Just head to dividends.fool.com to learn our picks for the best dividend stocks for 2016. Once again, that's dividends.fool.com, and just to make it easier on everyone, I will drop it in the iTunes description of this podcast.

Muckerman: You're a swell guy.

Crowe: You're making it so easy for all of our listeners.

O'Reilly: Such a nice guy.

Muckerman: Such a nice guy.

O'Reilly: I go above and beyond for our listeners. So we talked about what to avoid and how really there's not a lot of multidecade dividend-increasing energy/materials stock. It's really, really hard because it's a commodity business.

What are some traits that the average guy can look for -- guy or gal, I apologize -- in companies that can maintain and consistently grow dividends?

Crowe: Well, like you said with cash flow, I think it's the ability to preserve your cash flow based on your business model. We talked about vertical integration for somebody in the energy space where, when one is weak, such as when oil prices are cheap, then all of a sudden refining becomes a more profitable venture and then vice versa.

So you have kind of a smoothing out of the cash flow. And you can also look at, even in the energy space, surprisingly, there are a lot of companies who aren't directly exposed to commodity prices. And they're more based on the more generic supply and demand. You look at somebody who specializes in transportation and logistics.

If you work in those middlemen sort or ranges where you're working off of contracts, where you're working off of a way of pay, only charging for volume that moves through your system. And if in terms of the utilities and things like that, the ability to get a little bit closer to the customer, where you don't see as wide of swings in price as you may see on the kind of the front when it comes to the generic material itself.

So those sort of things will help isolate a company's cash flow from the cyclical aspect of this business, and that can actually help to preserve its dividend in a much more stable way.

O'Reilly: Yeah, and just to kill the suspense in diving down to the energy Dividend Aristocrats, it bears out exactly what you're talking about. I mean you've got Northwest Natural Gas, they're a distributor, Helmerich & Payne, a rig owner. Consolidated Edison, that's like the quintessential utility, MGE Energy, same deal, Atmos Energy, natural gas distribution utility, ExxonMobil ,the integrator of integrated, Energen Corp., it's an oil producer but they actually just recently cut their yields -- so just probably take them off the list -- and Chevron, another integrative oil producer.

So is that where people should be looking for dividends, guys?

Muckerman: I mean, if you want a company that's just going to plod along in the markets and pay a consistently rising dividend, then sure, yeah, that's great. But you're not going to see a whole ton of capital appreciation from these companies.

Crowe: But at the same time, I mean there is a lot of power in that. I think one of the things that's underappreciated -- when we talk about dividends, dividend stocks, we always think of them as an income stock. That idea where it has to be somebody who is looking to use the dividend to simply pay for lifestyle or supplement income in retirement, something like that. But for younger investors, dividend investing can be extremely powerful in that dividend reinvestment model. And we may look at it and say, "Oh, these companies don't grow at a very fast clip." However, from an individual investor standpoint, that reinvested dividend model on some of these companies that have shown year in, year out they can do dividend payments and dividend increases -- that can be a pretty powerful tool for building wealth in the long term.

Muckerman: Then if you're holding it 20, 30 years, you can almost get the stock for free. Essentially, if you look at a dividend, instead of income, if you look at a dividend as lowering your cost basis, each dividend you pay you get the stock cheaper.

O'Reilly: What was that statistic over the last 100 years, like, some huge chunk of total returns have been from dividends? It's like 40 or 60% of total returns in the stock market.

Muckerman: Well, yeah, if you look back over the last five to 10 years, the increase I think it was like 120% of cash flows have now been paid as dividends or share buybacks, up from like 60% just a handful of years ago. So it's become a financial engineering tactic for a lot of companies lately. And some people are worried about that reversing and harming the value of the stock market. But it's become a very important part of a CFO's job to pay dividends and buy back shares.

O'Reilly: So before we head out here, any companies on the above list that you guys like in particular that you want to highlight? Or maybe aren't on the list? I'm sure, Tyler, you...

Crowe: Well, let Taylor start it off. It doesn't even have to be on the list.

Muckerman: Oh, yeah, on the Dividend Aristocrat list, I'm personally not going to invest in any of those companies. Dividend payers in the energy sector that I like -- I mean the ones that I own, Halliburton, I'm not trying to talk with my game, but I own it because I like it. So that's one of my favorite dividend payers.

O'Reilly: They're of course integrated, huge exposure to...

Muckerman: Yeah, so they have their equipment and services provider offshore, onshore, natural gas, oil, predominately fracking. So once that picks up -- and it hasn't even started to pick up really around the world -- I'm expecting that to be a nice decade or so tailwind once China and Argentina and others get on board with fracking. Because it's going to have to happen at some point.

O'Reilly: Cool.

Crowe: Well, since I do own ExxonMobil I guess I'll have to say that one since it is on the Dividend Aristocrat sort of level. The reason that I do like ExxonMobil over the long term is when compared to many of its peers, when they're building out their projections on how to develop new fields, they have a much more conservative approach in terms of, at this certain price point we have to have at least breakeven or a certain amount of return. And for ExxonMobil at about $55 compared to the $60, $70 range for most of its integrated major peers. It has the reputation for years now, decades even, of being the one company that invests through the cycle.

So you know it's not trying to push a whole bunch of projects out the door when cash flows are great, and then shutting down when things get weak. And it gives them that level of consistency that I think most investors are looking for when they're looking for that income sort of play.

O'Reilly: Cool. Well, that is it for us, Fools. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at IndustryFocus@Fool.com. Again that's IndustryFocus@Fool.com. As always, people on this program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman and Tyler Crowe, I'm Sean O'Reilly. Thanks for listening and Fool on!

Taylor Muckerman owns shares of Halliburton and Starbucks. Tyler Crowe owns shares of BHP Billiton Limited (ADR) and ExxonMobil. The Motley Fool owns shares of and recommends Halliburton and Starbucks. The Motley Fool owns shares of ExxonMobil and has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $43 calls on Coca-Cola, and short January 2016 $37 puts on Coca-Cola. The Motley Fool recommends Chevron, Coca-Cola, Johnson & Johnson, and Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.