Is dividend growth done?

As dividend growth slows, investors should seek stocks with solid current payouts and avoid turning toward more speculative fare, says Josh Peters.

Josh Peters, CFA 6 April, 2016 | 5:00PM Jeremy Glaser
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is the editor of our DividendInvestor newsletter. We're going to look at recent trends in dividend growth and what it means for dividend investors.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: We've seen a slowdown in earnings recently. Has that also translated into a slowdown in dividend growth?

Peters: Yeah, we are starting to see dividend growth slow down. We've been at what has historically been a very, very high rate of dividend growth for the S&P 500 to use that as a benchmark for the market. I mean, you don't typically see year after year after year of double-digit increases, but that's what we've had actually since dividends bottomed out after all the dividend cuts back in 2008-09. So, some of that was the recovery in earnings, that's good. Some of it is an increase in the payout ratio and I've believed for a long time that companies have devoted too little a share of their earnings to dividends, prioritizing buybacks especially, as well as acquisitions as a use of cash. I wanted to see the payout ratio of the market come up. The market historically would yield between 3% and 6% up until the mid-1990s and since then we've been lucky to yield 2%. I think that older higher-yield environment with a higher payout ratio is better for investors. I think it's better for the companies, too--provides more discipline in capital allocation. But at some point dividends aren't going to keep growing unless earnings are growing, too, and with the slowdown in earnings growth you are also seeing that slowdown in dividend growth as well.

Glaser: So, when you are looking at potential opportunities now, how does that factor into your calculus? Do you worry that growth is going to be so slow that you need to get paid more upfront?

Peters: I think that's a really good way to think about it, which is, some people assume that if dividend growth slows then this dividend thing is over. It's time to go off and find growth elsewhere. And I would maybe start by asking where? We've seen what happened with the FANG stocks, which is, if you pay too much for growth just because it happens to be scarce and you ignore yield as a component to your total return, you're going to get burned.

I think it's much more advantageous to structure your portfolio in a way so that you've got lots of stocks that yield 3%, 4%, 5%; get you halfway or thereabouts to a good long-term total return on income alone. That really takes the pressure off companies to generate earnings and dividend growth in order to meet your returns, the returns that you need to meet your financial objectives. But when growth slows down across the board then you also have to realize that even from those higher-yielding stocks you may not get the growth you expect.

[Consumer] staples is a great example, where these are companies that historically had had higher-than-average payout ratios and over the last couple of years we've seen a lot of companies continue to raise their dividends even though earnings haven't been growing much. I mean, you've had pressure on the consumer, say, in the packaged food area. General Mills has struggled to grow earnings because people aren't spending as much time in the middle of the grocery store. They are out on the edges where there are not so many other products. Foreign currency has really been a huge headwind for a name like Philip Morris International or Procter & Gamble, and you've seen dividend growth rates coming down in these high-payout areas. I think the dividends are still reliable, but everything is in an opportunity cost trade-off context, right? So, when I see these stocks yielding 3%, 4%, even if I'm getting only mid-single-digit growth, I think that's better than walking away from income and saying I'm going to go off and try to chase more-speculative forms of returns.

Sometimes we just have to suck it up, admit that there is not as much return to be extracted from the market. And in that context, what do you? You minimize risk. You minimize risk for the same return. You don't go out and say, "Gee, I really need this double-digit growth," or something like that. If you stretch for more than what's available then you're going to be even worse off.

Glaser: Other than staples do you think other kind of historically higher-yielding sectors like utilities or REITs also kind of meet that criteria today?

Peters: Well, with utilities I think you have kind of a unique situation in that I would argue fundamentally the industry is in the best shape that's been in for 50 years. You've got lots and lots of regulated utilities that have gotten rid of their unregulated businesses, their merchant power or trading operations or just totally wild forays into completely different industries. The industry has really cleaned itself up. There is a lot of opportunity for investment in their rate bases, mostly on the transmission and distribution side, harden those grids, improve efficiency as we transfer from coal into more natural gas and renewables. That's more opportunity even for T&D utilities to invest, to connect these new sources of power. And the regulatory environment is generally pretty good. Regulators are supportive of these investments even though they may mean higher customer bills.

I mean, you can go in a lot of cases historically and look and see utilities can go five, 10 years no increase in earnings at all if they don't have rate base growth, if the regulators are really coming down on them hard and you can still find a few individual utilities that are not in such great shape. But for the most part, this has turned into a nice mid-single-digit, in some cases upper-single-digit type of growth story that has 3%-4% yields in some cases, on the right day, maybe even as much as 5%. I like that a lot. I think that the new growth that you find in utilities that you haven't had in a while insulates them from some of the interest-rate pressures.

On the REIT side, I think it's more of an interest-rate game. I'm willing to accept interest-rate risk and in the case of a name like a Realty Income or Ventas or Welltower, the two healthcare REITs that I own, because I think they have very good growth prospects and they have locked in long-term leases with their tenants that provides you with a lot of cash flow visibility, and they have done a good job managing their balance sheets. But if you have REITs that are vulnerable to increases in interest rates, if their cost of capital goes up and then can't grow through acquisition anymore then you may see the same kind of slowing growth that would encourage you to maybe hold out for a better yield at this point.

Glaser: Josh, thanks for sharing your thoughts with me today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
General Mills Inc64.11 USD0.09Rating
Philip Morris International Inc93.05 USD3.02Rating
Procter & Gamble Co146.34 USD-0.68Rating
Realty Income Corp49.62 USD-0.08Rating
Ventas Inc42.20 USD1.91Rating
Welltower Inc80.46 USD0.32Rating

About Author

Josh Peters, CFA

Josh Peters, CFA  Josh Peters, CFA, is a portfolio manager for Morningstar’s Investment Management group and edits the monthly newsletter Morningstar® DividendInvestorSM.

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