Dividends: Icing on the Cake
Stephen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Dividends are powerful. Historical analysis has shown that over the long term, dividends have significantly contributed to the total return of the stock market. For example, a study published in the book Triumph of the Optimists: 101 Years of Global Investment Returns found that from 1900 to 2000, a portfolio that reinvested dividends outperformed the price appreciation (capital gains) of the market by a factor of nearly 85. Jeremy Siegel found that between 1957 and 2002, the S&P stocks in the top fifth (20%) of dividend yields returned more than 3x the overall return of the entire S&P. At the beginning of June 2007, a single share of Procter & Gamble (NYSE: PG) would have cost around $62.00. Five years later, the stock still sits around this price, if not slightly down. However, over that same period the stock has returned $9 a share in dividends, a 14% total return.
It’s important not to get caught chasing any stock with a high yield, though. A 2006 study from Credit Suisse found that between 1990 and 2006, the best returns came from high yielding stocks with low payout ratios. This makes sense, because companies with high payout ratios may be strained to maintain those dividends in the future and have less retained earnings to pursue growth. Based on this idea, I screened the market for companies yielding at least 3.5% with payout ratios less than 40%. I’ll begin with a brief description of each and follow with a comparison.
Autoliv (NYSE: ALV) is a developer and manufacturer of vehicle safety systems, including airbags and seatbelts, whose customers include nearly all the major auto manufacturers. The company accounts for one third of the American airbag market and about half of the European market. There is growth potential in the Chinese auto industry and in the aging American vehicle inventory that will eventually need replacement. The company has recently suffered a black eye due to antitrust violations that are still under investigation by the European Commission.
Seagate Technology (NASDAQ: STX) is the largest manufacturer of hard disk drives (by sales). The Thai floods of 2011 hit the company’s supply chain hard, but the company is looking to rebound and is making smart moves into cloud storage. The stock is trading at a P/E of less than 6 and less than 1x sales, and the company recently received a big vote of confidence from David Einhorn, the founder of Greenlight Capital.
Kronos Worldwide (NYSE: KRO) is a leading producer of titanium dioxide pigments, which are the largest commercially used whitening pigments. They can be found in paints, coatings, plastics, paper, inks, foods, medicines, and toothpastes. The control structure of the company is a little convoluted: 50% of the company stock is owned by Valhi Inc, and 30% is owned by NL Industries, two publicly traded. Valhi Inc owns 83% of NL Industries, and 90% of Valhi is owned by Harold Simmons, the billionaire businessman who developed the concept of leveraged buyouts. In short, your vote as a shareholder in this company is going to mean squat.
A high yielding stock can quickly lose its luster if the dividend cannot be sustained. Two metrics that can be used to check this are the earnings and free cash flow payout ratios. Simply put, these ratios measure the financial burden of paying dividends on net income and free cash flow. The higher this number, the harder it is for the company to maintain the dividend, especially during tough times. Additionally, companies with large debt burdens may become financially stressed in the future, again affecting dividend payments. Therefore, I check the debt to equity ratio and interest coverage to get a quick pulse on the company's financial health.
Ratios are calculated from last 10-K, Debt to Equity and Interest Coverage calculated from last 10-Q
Everything looks pretty good based on just these metrics. Seagate looks especially intriguing, contributing only 18% of free cash flow towards dividend payments. The company had to suspend dividend payments in FY 2010 to enhance liquidity, so consistency in the future may be a concern. Autoliv also looks attractive, but until the anti-trust investigation is complete and the potential financial impact on the company is known, I am going to stay away. Kronos is a company I would not invest in because it is effectively controlled by one person.
While the dividend yields are attractive, each stock comes with some risk, and I would consider more than dividends alone when deciding to invest in a company. However, if you can find a sound business with strong management and good fundamentals, a healthy dividend yield can be the key to market-beating returns.
drfrank1 does not own shares in any company mentioned in this post.