There has been much chatter about potential increases to dividend tax rates and the effect it will have on average investors. While no one can predict with any certainty the outcome of potential expiration of Bush era tax cuts, dividends and the income they provide remain an important if not necessary component in most income investor portfolios.
Here's why. Quite simply, what are the alternatives? Howard Silverblatt, senior index analyst at S&P/Dow Jones Indices LLC, puts it this way:
Where are you going to put that money? Competitively, there isn't much to take dividends' place. On a risk-reward basis, dividends and yield are still attractive rates.
Income is very low and hard to come by. A dividend-focused strategy, even on a higher-tax basis, still compares favorably to yields offered by cash, Treasuries and certificates of deposit (CDs).
To the average investor or retiree who depends on dividend income, a potential dividend tax increase does not eliminate the basic need for income. It just might be a little more expensive from a tax perspective.
For dividend equity investments, we look for companies that exhibit the following characteristics:
- History of generating consistent and stable cash-flows
- Consistent returns-on-assets (a factor in dividend sustainability)
- High level of earnings quality
- Solid management team
Cash-flows: Think of cash-flow as oil in an engine. Without oil, the engine will seize and things come to a grinding halt. Companies who generate most of their cash-flow from actual operating activities display healthier liquidity profiles than companies who rely on balance sheet maneuvering for "cash".
Earnings Quality: Earnings are the result of operating and non-operating activities. Earnings supported mostly from operations (i.e. paying customers) indicate a higher level of earnings quality than earnings generated by non-cash and accounting maneuvers.
An earnings report is valuable but the constituents to earnings are more so. To a dividend investor this distinction is essential to the safety and sustainability of the dividend going forward.
Asset Returns: For companies with "maturing" or slow-but-steady growth businesses, we look for a history of solid returns-on-assets (ROA). Asset returns are important because they tell us how efficiently CAPEX, acquisitions, restructurings, and other initiatives are contributing to overall profitability of the business. Consistent asset returns are also an indication of effective management.
Below are two companies who meet our baseline criteria. We also believe each company will continue to provide consistent dividends going forward regardless of any potential change to dividend tax rates:
ConAgra (CAG): The packaged food sector is competitive and capital intensive. We have followed CAG for years and consider it a "healthy choice" for an income investor to consider.
Management reported a solid Q1 2013 and raised its quarterly dividend to $0.25 per share. Current yield is 3.60%. Credit quality is investment grade and management is committed to a strong balance-sheet.
We also like how management has rationalized capital allocation and balanced product initiatives in recent years. CAG has done a good job of leveraging portfolio brands (organically and via acquisitions) as a means to generate solid cash flow performance.
Waste Management (WM): There is nothing sexy about garbage, but lots of it is generated every day. Somebody has to collect, process, recycle and dispose the stuff. WM does all this and is also a major player in the waste-to-energy arena.
Despite commodity headwinds and the capital intensive nature of their operating model, WM has been successful at generating healthy cash-flow from its operations. In the recent Q3 2012 results, management indicated they expect free cash-flow to grow in 2013 and beyond.
Debt-to-capital ratio for WM is 60% and weighted average cost of debt is currently 5.1%, both of which are well covered in the company's capital allocation policy.
Management remains focused on a stable balance sheet and a balanced approach to returning capital to shareholders and share repurchases. Current dividend is $1.42 (annual) and yield is a generous 4.5%.
Summary: CAG and WM are just two ideas for dividend-stock investors to consider. The baseline characteristics discussed above are intended as a starting point to evaluate potential dividend investments. Thorough due diligence and analysis is always recommended.
A primary screen to analyze cash-flow, earnings quality and asset returns helps to filter out weaker prospects and identify candidates worthy of further analysis.
In using these critical metrics, we have been able to capture a lion's share of income potential and avoid dividend traps. To a dividend investor, safety and sustainability are paramount.