Seeking Alpha
Research analyst, CFA, Director of Research, long/short equity
Profile| Send Message|
( followers)  

Summary

  • In the current rising rate environment, Argus recommends focusing on dividend growth over dividend yield.
  • We would focus on companies that have boosted their dividend for many years consecutively and that have an above average rate of dividend growth.
  • The attached table shows 20 diversified, high-quality, and Argus BUY-rated stocks with well-above-market trailing 5-year dividend growth and annualized total return.

Dividend income is an important element of total return. But nicely yielding stocks are perceived as being at risk in a rising rate environment. What should the income-dependent investor do in this current climate of rising interest rates?

Argus recommends focusing on dividend growth over dividend yield. Specifically, we would focus on persistent dividend growers -- companies that have boosted their dividend for many years consecutively -- and companies that have an above average rate of dividend growth. We would scour for dividend growth in sectors outside the traditional equity-income areas of utilities, REITs, and MLPs. And for all names, we would track some measure of dividend safety; our favorite is free cash flow coverage of dividends.

The Current Interest Rate Environment

After hitting 1.63% in May 2013, the 10-year yield had an unbroken climb higher to 2.97% on 9/5/13. From above 3.0% at year-end 2013, the 10-year yield has retraced again in the new year. Spurred both by geo-political fears and scarcity (as lower deficits reduce Treasury issuance), the long-yield is again near 2.5%.

The short end of the curve, however, could begin to rise as early as 2015. Once tapering is done, the Fed may look to preempt any incipient inflation with a series of hikes in the Fed funds and discount rates.

Pressure on the short end could translate into higher rates at the long end. We are reiterating the Argus forecast for a 10-year Treasury yield in the 2.755 range across second half of the year, with the potential for rates to rise past 3.0%. Once the Fed actually begins hiking short-term rates, the long-yield could potentially rise to 3.5% and beyond.

Stock-Market Behavior Amid Rising Interest Rates

A 50-year chart of the 10-year yield shows two great tendencies. Long rates broadly rise from 3% in 1953 to 15% in 1980; and rates broadly decline from the 1980 high to the low of 1.6% reached in spring 2013.

Within those broad trends are multi-year periods in which rates clearly rise or fall. Our research has demonstrated that the stock market can maintain its long-term uptrend during extended periods of rising rates. Interest rates rose across 1995-96 and again from 1998 to early 2000 without disrupting the great 1990s bull market. The long yield was also in a clearly rising trend from 2003 through 2006, or for most of the 2003-07 bull market. Reaching further back in time, the stock market rose 14% during 1986 in a rising rate environment. And the S&P 500 rose 25% in 1980 even as rates were approaching their double-digit peak. In 2013, the stock market delivered its best total return of the post-2008 bull market even though the long yield nearly doubled across the course of the year.

Not every sector in the market rallies in a rising-rate environment, however. In 2012, a year in which the S&P 500 appreciated 13.4%, the Utilities SPDR (NYSEARCA:XLU) declined 2.2%. And in 2013, a year in which the S&P 500 appreciated 29.6%, the XLU SPDR delivered a lagging 11% gain. All of the gain was realized in 1H13; the SPDR lost about 2% in 3Q13 and gained about 2% in 4Q13.

Negative Linkage: The 10-year yield and income stocks

Senior Analyst and Argus Director of Utility Research Gary Hovis has long studied the linkage between high-yielding equities and long yields. The differential between long yields and dividend yields tends to be stable over time. At the same time, those differentials may not be the same for companies with varying levels of economic exposure.

A company like a utility whose dividend is funded by rate-payers is lower risk, and its yield differential to Treasury yields is low. A company such as an auto-maker whose dividend is funded by the level of economic activity is higher risk, and thus may have a higher differential. But for both companies, those differentials tend to be stable.

Historically, when Treasury yields change trend by either rising or falling, those yield differentials are maintained. If Treasury rates are rising and differentials are stable, and assuming no change in dividend policy at a company, the only way for that company's dividend yield to adjust upward is for the stock price to decline.

Utility Research Director Hovis noted that as the era of deregulation flowered in the 1990s and early 2000s, utilities engaged in more and more non-regulated activity. Consequently, the correlation between 10-year yields and dividend yields (and thus utility stock prices) frayed and in some cases was severed altogether.

But after the Enron disaster and a few other non-regulated fiascoes, many utilities exited or scaled back non-regulated activities. As more utilities "stick to their knitting" and focus exclusively on regulated operations, Gary believes the traditional relationship is reasserting itself.

Dividend Growth Supports Superior Total Return

We have already explained the risks of high-yield investing in a dynamic rate environment. Why then go anywhere near income stocks at such a time? Investors need income. Moreover, we have found that dividend-growth stocks tend to hold their value better in periods of rising rates and deliver solid total returns in all markets.

Fast Dividend Growers

To perform our analysis, we loaded the Argus coverage universe into our database and sorted for all companies with a least a 5-year dividend history. This eliminated lots of smaller growth names and even some giants (Cisco (NASDAQ:CSCO), Apple (NASDAQ:AAPL)) with generous current dividends but no five-year history. We then sorted the remaining 300 or so names by 5-year annualized dividend growth, while also recording five-year annualized total return.

Over the past five years, the S&P 500 has averaged 20% total return while growing its cumulative dividend at a 4.5% annualized rate. We sorted for "fast" dividend growers: companies that have a five-year annualized dividend growth rate exceeding 20%. We also sorted for 5-year annualized total return matching or better than the market, solid free cash flow coverage of dividend (with some sector adjustments), and current yield

Among BUY-rated stocks in Argus coverage, we identified a diverse list of 20 superior dividend growth companies. This group of 20 companies spans eight of the 10 S&P sectors. Over the past five years, this group has averaged 5-year total annualized dividend growth of 31.4%; 5-year total annualized return of 28.2%, free cash flow (FCF) coverage of dividend costs averaging 4.6-times; and 2.0% current dividend yield.

Sector Diversity & Cash Flow Support

While we regard our list to be composed of best-of-breed names, investors should still keep an eye out for signs of financial deterioration. One of our favorite means of measuring financial strength is to compare annual cash flow from operations with the annual cost of dividends paid. These data points can be found in the annual Cash Flow Statement, required to be filed by all public companies.

Utility companies are a different story. They typically have much lower cash flow coverage. However, their cash flows are not economy-sensitive; instead, they are generated by rate-payers. As such, we are comfortable with lower cash flow coverage for utilities.

Finally, we note that our list of 20 companies contains technology, materials stocks, industrial, healthcare, financial, energy, consumer staple, and consumer discretionary stocks. The point is that, in compiling a dividend growth portfolio as in any other part of investing, it pays to be diversified.

Conclusion

Dividend growth is not an ironclad defense against a down market. But for investors requiring income, dividend growth outperforms in a rising rate environment. Dividend growth stocks, when purchased and held, also provide a rising yield on your original cost basis. Even though stated yield on a high-total-return stock may be 3%, your effective yield based on your original cost basis can be much higher.

In our view, dividend growth is a superior strategy in relation to chasing high yield for long-term returns across the entire market cycle.

The table below shows 20 diversified, high-quality, and Argus BUY-rated stocks with well-above-market trailing 5-year dividend growth and annualized total return.

Name

Tkr

Price


Annlzd. 5 Year Total Return

Annlzd. 5 Year
Dvdnd. Growth

Dividend
Yield

Market Cap (USD)

GICS Sector

Williams Sonoma

WSM

68.37

40.99

21.67

1.84

6,435

Consumer Discretionary

Royal Caribbean Cruises

RCL

62.58

36.47

27.23

1.80

13,912

Consumer Discretionary

Coca-Cola Enterprises

CCE

47.73

32.27

26.30

1.89

11,720

Consumer Staples

CVS Caremark

CVS

78.38

19.85

28.67

1.21

91,644

Consumer Staples

Whole Foods Market

WFM

36.53

25.97

35.69

1.20

13,427

Consumer Staples

HollyFrontier

HFC

45.70

42.20

60.75

7.00

9,080

Energy

Williams Companies

WMB

57.97

38.62

29.03

2.59

43,303

Energy

Simon Property Group

SPG

170.47

31.19

20.58

2.93

52,958

Financials

Lazard Ltd.

LAZ

53.63

11.82

27.54

2.52

6,997

Financials

Prudential Financial

PRU

88.98

19.10

27.96

2.09

41,109

Financials

Stryker Corp.

SYK

80.09

17.28

24.16

1.47

30,321

Health Care

Amerisource Bergen

ABC

77.40

32.48

37.30

1.15

17,480

Health Care

Cummins Inc.

CMI

145.35

31.61

28.99

1.72

26,728

Industrials

Union Pacific Corp.

UNP

100.64

31.59

25.78

1.69

90,317

Industrials

Southwest Airlines

LUV

29.21

31.19

58.49

0.62

20,209

Industrials

Danaher Corp.

DHR

75.21

20.12

33.03

0.33

52,698

Industrials

Seagate Technology

STX

59.13

40.96

43.97

2.82

19,309

Information Technology

Texas Instruments

TXN

47.35

17.04

22.22

2.49

50,549

Information Technology

Altera Corp.

ALTR

33.02

13.20

24.57

1.82

10,202

Information Technology

Ashland Inc.

ASH

108.56

29.90

22.16

1.25

8,460

Materials

AVERAGE

28.19

31.31

2.02

30,843


Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Source: Dividend Investing? Buy Growth, Not Yield