What You Should Look For In The Perfect Dividend Stock
If you’re a regular reader of this blog, you might have noticed that I’m not a big fan of dividends. Personally, I would rather invest in a company that’s using excess cash to pay down debt or buy back stock — a more tax efficient method of returning cash to investors.
Buybacks and dividends are fundamentally the same; they’re both methods of distributing cash to shareholders. What’s more, assuming that taxation is identical, there are no transaction costs, dividend funds are reinvested (by the investor) at the same rate, and the stock is trading at a fair price, then there’s no clear identifiable difference between buybacks and dividends.
However, in the real world, these assumptions do not hold. Therefore, from the shareholders point of view, buybacks offer more flexibility because they allow the shareholder to control the timing of taxes.
The data shows that the most fundamental difference between buybacks and dividends is the attitude of executives. Specifically, executives tend to believe that maintaining the dividend is on par with investment decisions such as capital spending while buybacks are linked more to residual cash flow. As a result, buybacks tend to be viewed as a lever that can increase earnings per share under the right conditions while dividends provide a strong signal about management’s commitment to distribute cash to shareholders and its confidence in the future earnings of the business.
Unfortunately, management’s commitment to dividends can also damage a company’s prospects. Indeed, as I’ve covered before (here) enterprises that are set on returning the majority of earnings to investors via dividends chronically underinvest in growth. As management seeks to protect the dividend at all costs, growth spending takes a back seat.
Dividends are key
Having said all of the above, an overwhelming volume of research shows that dividends are the most significant driver of equity returns over the long-term. This research can’t be ignored.
For example, according to investment bank Société Générale since 1970 US equities with dividends reinvested have produced an annualized real return of 5.2%. However, if dividend payments were spent instead of reinvested over the same period, the average investor’s real return would be 3% per annum. Excluding dividends entirely, equities have produced an annualized real price return of only 2.2% since 1970. The compounding effects of the dividends really do dominate returns in the long run.
Unfortunately, picking the best income stocks to help you reap the benefits dividend compounding isn’t as easy as it may first appear. Contrary to popular belief, if you want to achieve the best long-term returns from dividend stocks you should be looking for the companies with the lowest dividend yields.
According to SocGen’s research, on average, the spread between the expected dividend yield (the payout analysts expect) of a particular stock, and the realised yield (the payout that investors actually receive) starts to widen above 4%. In other words, if a stock’s expected dividend yield is greater than 4%, the chance of the actual payout being less than the market expects, increases with every 100bps increase in yield, as the chart below illustrates.
SocGen’s research appears to show that high dividend yields should be avoided. Even index trackers can’t be trusted. Take the FTSE World High Yield index for example. As shown below the index has consistently produced a realised yield below what has been expected. Many of the stocks in the index yield more than 4%.
Dividends: Hunt for quality
Unsurprisingly, SocGen’s research on dividends concludes that the companies with the most secure dividends have two key qualities; 1) strong balance sheets; 2) high-quality businesses.
SocGen’s preferred methods of calculating a company’s balance sheet strength and quality, (as a result its dividend sustainability) are the Merton model (balance sheet strength) and Piotroski F-score.
The Merton model looks at the equity of a firm as being a call option on the firm’s assets. SocGen employs the model to determine a company’s ability to service its debt, meet its financial obligations and to gauge the overall possibility of credit default. Companies with the highest Merton model scores have produced the best returns for investors over the long-term with the least volatility.
Also, the evidence shows that the shares of companies with higher F-scores have outperformed those of lower quality peers.
The bottom line
So all in all, the evidence is pretty clear. If you want to achieve the best returns buy quality dividend stocks and don’t chase yield. Chase quality and the returns should follow.