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Market Intelligence

Run, Forrest, Run

Monday, March 31, 2014

Run, Forrest, Run

By Kevin Dehod, President

Like the famous Tom Hanks movie Forrest Gump, Forrest was told to “Run, Forrest, Run!” At McLean & Partners, our investment focus is “Grow, Dividend, Grow!” A combination of low interest rates, investor demographic trends, and the return of investor confidence in equities has served to reinforce the popularity of dividend growth investing.

McLean & Partners has focused on fundamental dividend growth investing as our core investment style since founding the firm in June of 1999. In this article, we will be focused on three main points; the case for dividend growth investing, why looking at companies that just initiated dividend is important, and why it’s important to look globally for the best dividend growth opportunities.

First, although dividend growth has become increasingly popular, it continues to be a rewarding investment strategy over both short and long time periods. Dividends and dividend growth continue to be significant drivers of long-term stock returns. Dividend payments are made in cash and they are a good indicator of management’s outlook for future cash flow. A company requires a growing stream of earnings and free cash flow to support higher dividend payments. Assuming a consistent payout ratio and the prudent use of debt, as a company’s dividend grows, the share price typically follows suit.

Figure 1 compares the performance of US dividend growth stocks since February 1972 against the overall S&P 500 Index and other categories. The margin of outperformance is significant with annual returns of dividend growers being 33% higher than the overall market. It should also be noted that dividend growth stocks exhibited 10-15% lower risk when compared to the S&P 500 Index as measured by standard deviation.
 

Figure 1: Growth of $1,000 Investment February 1972 - February 2014

  

Source: Ned Davis Research

The current investment environment is quite positive for dividend growth investing among US and Canadian companies. Corporate cash balances remain at record levels as earnings and cash flows have recovered from the depths of the 2009 financial crisis. In addition, company management and boards have a renewed focus on returning cash to shareholders in the form of dividend increases. In the US for instance, option grants as a percentage of outstanding shares are down 75% from 10 years ago. Our research team recently met with a company where the CEO has opted to receive the bulk of his annual compensation through share ownership and dividends. Also, activist shareholders have forced companies to increase dividends and buyback shares rather than sitting on cash. As a result of these events, a record 415 of S&P 500 listed companies currently pay a dividend. Furthermore, last year 339 of S&P 500 companies raised dividends with an average increase of 16%. While earnings growth has lagged in Canada over the last three years compared to the US, Canadian companies have nevertheless been raising dividends resulting in dividend growth for the overall S&P/TSX Composite Index of 8% in 2013. Figure 2 highlights the annual distribution increase for unit holders in the M&P Global Dividend Growth strategy versus the market.

Figure 2: 2013 Annual Dividend Growth

Source: Bloomberg, CIBC Mellon

The primary factor driving future dividend growth relates to cash flow, earnings growth, and corporate payout ratios. Payout ratio is the percentage of earnings that a company pays out in the form of a regular dividend to shareholders. Generally speaking, a lower payout ratio is preferable as this is a sign of a company with sufficient capital to maintain and grow their business while also ensuring the dividend payment is sustainable. It is important to note that yield alone is not indicative of a stock’s future value, as a high dividend yield with a high payout ratio can be a potential red flag for investors.

Given earnings for companies in the S&P 500 Index are at an all-time high; the current payout ratio is on the low end of the historical range at 36% (historical average of 50%). This implies that in addition to growing earnings streams, there is also capacity to generate dividend growth by way of increased payout ratios going forward. In Canada, the situation is the opposite as the current payout ratio for TSX composite companies is at 50%, right on the historical average.

Second, we believe it is important to be aware of companies that just initiated dividends. These companies typically have a low payout ratio and have the financial flexibility to quickly increase their dividends over the next few years. Our analysis identifies companies with the characteristics of dividend growers: businesses with strong free cash flow generation, a sustainable competitive advantage, reasonable payout ratio, healthy balance sheet, and a successful management team. All of these characteristics are factors supportive of returning excess capital to investors.

Two recent dividend initiators that we hold in our portfolio are Cisco Systems and Starbucks. Cisco Systems initiated a dividend in 2011 and has increased their dividend by 171% over the last three years. Starbucks also initiated a dividend in 2011, and has increased dividends by 44% and the stock has appreciated commensurately, providing a total return of 150%.

Both Cisco Systems and Starbucks would not meet the requirement for many of the dividend growth ETFs (exchange trading fund), which typically require over 10 years of increasing dividends before they are included in the fund. As a result, ETF investors potentially lose out on significant dividend increases and capital gains from these two companies.

Finally, it is important for investors to look globally for the best dividend growth companies. Emerging markets, such as Brazil and China, have companies that are quickly growing and returning cash to shareholders. By looking globally, we can diversify sector exposure, increase portfolio yield, and take advantage of lower valuations.

In 2013, 70% of the dividend growth within the S&P/TSX Index came from two sectors; financials at 43% and Energy at 26%. While dividend growth trends are well advanced in North America, corporations in Europe are just starting to consider raising dividends as corporate earnings and cash flows begin to recover. Today there are several countries that offer attractive dividend growth prospects and higher dividend yields that are available in the US or Canada. Figure 3 shows the current dividend yield of select regions. Recently we have been adding to our portfolio holdings in Brazil and China to take advantage of attractive valuations and adding dividend yields of over 3%.

Figure 3: Regional Dividend Yield

Source: WisdomTree Equity Research

In summary, Dividend growth continues to be an investment strategy that outperforms over time. Second, we continue to look for companies that are initiating dividends since they can add significant gains to the portfolio through growing dividend and higher capital appreciation. Finally, we continue to research companies globally, whether they are in the US, Europe, or Asia.

If you are interested in gaining further insight on our investment strategies which encompass Global Dividend Growth, please contact us at (403) 234-0005 or [email protected].

 


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