Income Investing With Low Payout Ratios

Dividends are the bread and butter of investing. If you don’t have dividend stocks in your portfolio, you’re holding yourself back.

According to credit rating agency Standard and Poor’s, over the last 80 years dividends have been responsible for 44% of S&P 500 returns. Between 1929 and 2012,  2012, an investment in the S&P 500 would have returned 5.2% per annum excluding income but 9.4% including dividend distributions.

When you compound the additional 4.2% of extra returns over the long term, it’s clear when you can’t afford to ignore dividends.

What You Should Look For In The Perfect Dividend Stock

Specifically, a hypothetical $100 investment made at the end of 1929 would be worth $6,566 by the end of March 12 based on price change alone. When you include dividends and the higher returns rate of 9.4%, the same hypothetical $100 investment would have grown to $162,925 over the period — 24.8 times more than without dividends.

income investing

Buying income stocks isn’t as straightforward as just purchasing the equities with the highest yields. The sustainability of the yield is key, and this means lower yields are better.

The trick to income investing

The best research on this comes from an equity research paper entitled High Yield, Low Payout, compiled by Credit Suisse analysts Pankaj N. Patel, Souheang Yao and Heath Barefoot.

These analysts simulated a dividend strategy from January 1980 to June 2006, limiting their universe to stocks within the S&P 500. They created equal-weighted decile baskets based on dividend yields as of each month-end.

What they found was that the best dividend stocks are those with a low payout ratio — both high and low yield.

income investing

These findings make a lot of sense. If companies are paying out all of their earnings to investors via dividends, they can’t invest in growth. So, even though investors will be pocketing the cash, earnings and capital growth will stall. On the other hand, if the company can both invest in its operations and return cash to investors, over the long term, the reinvestment will pay off (hopefully).

Another factor to consider is dividend growth. A stock that currently yields 2% or 3% may not be attractive to income investors today, but if the company can continue to compound its dividend payout at 10% per year, the distribution will double in 7.2 years.

If shares in ABC Corp. are trading at $100 and yield 3%, if the payout grows 10% per annum for 20 years, by year 20 the payout will be $20.18 per share, giving a yield on cost of 20%. If you think a holding period of 20 years is too long for a dividend stock, you should probably reconsider your strategy.

A few months ago analysts at Bank of America put out some research which showed that 23% of the S&P 500’s constituents support a yield of more than 5% based on their share price ten years ago and almost 70% support a yield of more than 5% based on the price 20 years ago. That’s compared to the fact that today only 2% of companies yield 5% or more.

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