In a recent article I summarized the lowest-yielding Dividend Champions - companies that have not only paid but also increased dividends for a minimum of 25 consecutive years. Specifically, I looked at those companies yielding less than 1%. There were five of them: C.R. Bard (NYSE:BCR), Energen Corp (NYSE:EGN), Franklin Resources (NYSE:BEN), Nordson Corporation (NASDAQ:NDSN) and Sigma-Aldrich (NASDAQ:SIAL).
The takeaway was that the low "current" yields weren't necessarily always low in the past, and each turned out to be a pretty solid investment over the last decade and a half. That is, the low yield precluded neither a reasonable income stream nor a solid total return. As such, an investor with a long-term time horizon might not want to automatically ignore these partnership opportunities.
It was interesting to see how each company ended up with such a low "current" yield -- despite the idea that the companies had increased their payouts for decades on end. It turned out that these companies raised the dividend by a slower rate than earnings growth, the P/E multiple expanded or a combination of the two occurred. Given this information, I was curious if the opposite was true. Did the highest-yielding Dividend Champions get to where they were because of faster dividend growth, a higher payout or P/E compression? And if so, did this have an effect on the return characteristics of these securities?
In order to investigate these inquires, I thought it might be useful to look at the highest-yielding Dividend Champions; specifically, those with "current" yields above 5% as of the end of last month. As a preliminary note, all data was viewed via F.A.S.T. Graphs, which in turn utilizes S&P Capital IQ. Keep in mind that these numbers might not exactly match other sources as the methodology can differ (for instance, a blended P/E and "adjusted" earnings are used), but the data points will work quite well for our purposes.
Universal Health Reality Trust (NYSE:UHT)
Beginning operations of Christmas Eve of 1986, Universal Health Reality Trust is a REIT specializing in healthcare and human service related facilities. At the end of last year, the company had 56 investment properties located in 16 states. Examples of facilities include: acute care hospitals, medical office buildings, rehabilitation hospitals and childcare centers.
The company has increased its dividend every year it has operated, for a 28 consecutive year streak. In the last 10 years, these increases have come in at a rate of 2% per annum and the company now has a "current" yield of 5.7%.
So how did the company get to this point? Well, in the year 2000 shares of UHT traded hands around $15. The company had earnings of $1.81, but funds from operations -- which were $2.54 that year -- is probably a more reasonable indication of the company's underlying operations. At the turn of the millennium, Universal Health Reality Trust paid a dividend of $1.84 -- resulting in dividend yield of 12.3% and a Price-to-FFO of about 6.
Last year the company reported FFO of $2.75 while paying $2.495 in the form of a dividend. The share price ended 2013 around $40 and has since inched up to about $44. In total this means that FFO grew by just 0.5% and, as indicated, the dividend increased at a rate of about 2% per year. Clearly growth was lacking, but it should be underscored that the dividend remained both intact and actually grew a bit each year.
Here's the interesting part: an investor of 2000 would have started with a 12% "current" yield. If they held until today, they would have seen a higher payment each and every year with a yield on cost reaching 17%. Yet the performance results do not immediately reflect this strong income component. Your price appreciation would have been about 8% per annum, while the total return -- including dividends -- would be just 12%. The implication is lasting: even an extremely high current yield, which grows over time, does not automatically translate to a better investment choice. As described in a previous article, Franklin Resources -- with a beginning and end yield of less than 1% -- had performance results that rivaled those of United Health Reality Trust during the same time period.
HCP, Inc (NYSE:HCP)
Aside from an obvious ticker, this California-based healthcare REIT also has a record of increasing its dividend for 29 straight years. Much like Universal Health Reality Trust, HCP operates properties in a variety of healthcare areas including: senior housing, skilled nursing, life science, medical office and hospital. It seems, at least considering these two examples, that the healthcare REIT space has a penchant for consistency. Today shares of HCP yield about 5.2%, with increases over the past decade coming in at about 2% per annum.
Interestingly, HCP's history is remarkable similar to that of our first example. In 2000, shares of HCP traded around $12 with a corresponding $1.61 in FFO per share and a $1.39 dividend. In turn, HCP had a beginning period dividend yield of about 11.5% with a Price-to-FFO of 7.5. Last year the company had FFO of $3.01 with a dividend payment of $2.10. Expressed differently, funds from operations grew by about 4.5% while the dividend grew by about 3%.
The total returns for HCP during the time period were not as outsized as one might imagine when first considering a huge and growing yield. The beginning dividend resulted in a nearly 12% starting yield, which increased over time. However, despite the price and dividend increasing, the total annualized return was also around 12%. This is certainly solid, but nonetheless telling. With a Coca-Cola (NYSE:KO) or Johnson (NYSE:JNJ), you might expect total returns to be much greater than the "current" dividend yield. In both of the first two examples, the total return ended up roughly matching the beginning dividend yield -- despite payment increases each year.
Mercury General Corporation (NYSE:MCY)
Per the company's website:
"Mercury General is the leading independent broker and agency writer of automobile insurance in California and has been on of the fastest growing automobile insurers in the nation."
In addition, Mercury also writes automobile insurance in 12 additional states along with mechanical breakdown and homeowners insurance. More pertinent to this article, the company has increased its dividend for 27 consecutive years and recently had a dividend yield around 5% (which has since dropped to about 4.8%).
In 2000, shares of MCY traded around $22 with earnings of $2.59 and a dividend payment of $0.84. That is, shares of MCY traded with a dividend yield of about 3.8%, a P/E of about 8.5 and a payout ratio of 32%.
Since that time, earnings per share have gone up, down and sideways; ending in negative earnings growth. Last year the company earned $2.18 -- for a trailing P/E ratio of 24 -- while paying out $2.45 in dividends, a clearly unsustainable 112% payout ratio. The total performance results don't completely reflect this lack of growth due to the large P/E expansion -- coming in at 9% annually. This was buoyed by a stable and growing dividend -- growth that was possible only because of an increased payout ratio.
On the topic of an unsustainable dividend, management had this to say in the most recent shareholder letter:
"Our strong capital position has allowed us to pay a dividend in recent years where the dividend payout ratio was above 100%. We recognize we cannot, on a long-term basis, have a payout ratio over 100%; but we also expect to improve profitability."
In other words, "we need to execute or the dividend is in trouble." I believe there's a good lesson here. In 2000, you had a solid starting yield with MCY, a low payout ratio and a history of growth -- it appeared to be a winning formula. Yet the company still has to execute. Today earnings per share stand where they stood 14 years ago. As a result, investors' returns have come from P/E expansion and a consistent dividend; both of which could now be in question.
Among the four examples, AT&T is likely the most widely recognized. The company spans the globe, providing connectivity services through an extensive collection of powerful networks. On an average business day AT&T's global backbone network carries 62.6 petabytes of data traffic. I'm not sure how much that is, but it sure sounds like a lot.
The history is a bit skewed due to the many mergers and divestitures, but a version of the company has increased its payout for 30 consecutive years. Today the company yields about 5.3%.
It's easy to think of AT&T as always having a 5%+ yield, as this has been the case for the last 6 years or so. Even 6% yields have been relatively common in the recent past. However, that has not always been the case. Let's go back to 2000 to see how AT&T got there.
At the turn of the millennium, shares of AT&T were changing hands around $49. During that time, AT&T had earnings per share of $2.15 and a dividend of $0.97. Expressed differently, shares traded at a 23 P/E multiple, with a 2% dividend yield and a 45% payout ratio.
Since that time earnings have grown by about 1.5% per year while dividends have been increasing by 4.5% annually (although this pace has slowed in the last few years). Today shares trade around $35, with underlying earnings power of about $2.60 and a dividend of $1.84. Said in another way, the P/E ratio has declined significantly while the payout ratio has increased -- both leading to a higher dividend yield.
Let's review. The first two examples were nearly identical. In both cases you had a healthcare REIT with a near 12% starting yield that turned into a 5% yield today. Performance results matched the initial yield -- around 12% annually -- and growth was slow to quite slow. So how did Universal Health Reality Trust and HCP end up with "high" yields today? Easy, take a much higher yield and don't grow very fast. Assuredly both still provided great returns and the income received was very solid. Yet expecting the same returns today, with a much lower starting yield, does not appear prudent.
The third example, Mercury General, has a "high" dividend yield today in spite of P/E expansion in the past. This company went from paying out a third of its profits to paying out more than 100% of what it made in a year. The overall return results -- at 9% per annum -- are certainly reasonable. However, unless the company is able to grow, both future return prospects and the dividend payment could be in jeopardy.
Finally, we have AT&T, which went from your run of the mill 2% yielder paying out half its profits to a 5%+ income producing behemoth. This was a result of a decrease in the P/E ratio and an increase in the payout ratio. The performance results were 1% annually -- entirely buoyed by the dividend, as the share price has not reached the 2000 level.
In three of the instances, a higher payout ratio was at least partially responsible for the high current yield. With the lowest-yielding Dividend Champions I previously outlined, the opposite was the case. The payout ratio often declined despite strong dividend growth.
Here's the intermediate takeaway: many search for high yield as an investment decision precursor. The reasoning might follow that high current income is like having the "bird in hand" while promised future growth would be equivalent to having "two birds in the bush." It makes sense; especially if you're primarily focused on immediate cash flow needs. However, keep in mind that there are risks involved with this strategy. As demonstrated above, the "high" yields often come at the cost of slower growth and/or less inherent payout safety. In the end, you're simply trying to find the appropriate mix that's right for you.
Disclosure: The author is long T, JNJ, KO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.