Lowell Miller's been pounding the table for dividends for decades. The founder and chief investment officer for Miller/Howard Investments has written three books dating back to the 1970s -- the most recent of which is "The Single Best Investment: Creating Wealth With Dividend Growth" -- first published in 1999, with an additional revision and publication in 2006.
Miller is and always has been an advocate of dividend-focused investment strategies. His own investment company has developed an index, the Strategic Dividend Index, an equal-weighted index made up of 30 promising, dividend-paying stocks. Currently there is one product that actually tracks his index, Citigroup's C-Tracks ETN Miller/Howard Strategic Dividend Reinvestor (NYSEARCA:DIVC) -- which just began trading on September 16th.
We caught up with Lowell Miller for an in-depth talk about why dividends still matter.
JVS: What, precisely, is a "dividend-focused strategy" to you?
LM: Many strategies provide a dividend yield as a kind of residual of other analytic or judgmental processes. Our approach is to begin with the dividend -- one that's reasonably high relative to the universe of stocks, supported by cash flows, and is likely, in our view, to grow.
JVS: Why's that?
LM: It's only logical that, over time, an increase in cash flows to investors will result in a commensurate increase in the value of the equity producing the dividend, all other things being equal. It's similar to income real estate; the property is valued in large part based on its cash flow. If the rents increase, then the value of the property increases. So the investor benefits from both higher income and from the appreciation that higher income induces.
JVS: So the investor wins coming and going.
LM: It doesn't matter whether the building is made of bricks or wood or concrete and steel. What matters is the cash flow. It's the cash flow that provides a current return, but at the same time also helps produce capital gains through its expansion.
In the equity market, it's a virtuous cycle unique to dividend stocks. So we start with the dividend, and limit our universe to dividend stocks, stocks with a dividend high enough to attract a "dividend constituency." That is, a group of investors whose motivations and emotions we understand… and can predict to some extent.
JVS: You mention the idea of "internal compounding" on your website. Can you explain precisely what you're referring to?
LM: "Internal compounding" refers to the virtuous circle in which rising dividends induce rising principal values. Further, dividends -- which are by definition always a positive portion of total returns (unlike price change, which can vary greatly) -- can be reinvested, providing an extra boost to the compounding principle; the dividends that are reinvested themselves produce dividends from the additional stock, and those additional dividends can be reinvested in yet more stock, which produces yet more dividends, and on and on.
JVS: The self-licking ice-cream cone!
LM: Few people realize just how important this principle is in achieving long term returns from equities. Ask a financial professional what the impact of dividends is on total returns, and he or she will tell you "about 50%." They've seen superficial journalism or sell-side reports showing this, but those studies only follow periods of ten years or so. Anyone who's studied compounding knows that the effects magnify over time. Indeed, In the most recent edition of the Ibbotson tracing of asset class returns (the yearbook, now owned and published by Morningstar), since 1926 $1 grew to $144 based only on capital appreciation. But $1 including capital appreciation plus the receipt and reinvestment of dividends rose to $4,676. In other words, dividends and the reinvestment of dividends accounted for roughly 96.9% of total returns since just before the 1929 crash. People generally don't know this because what they "know" are rules of thumb and tidbits from pundits, rather than the actual statistical facts.
JVS: You made a strategy shift in 1989, tilting decidedly more towards the dividend-focused strategy. What caused that particular strategic shift?
LM: We started out with a strong interest in quantitatively measured timeliness, today referred to as "momentum." This idea proved of little interest to institutions and their consultants at the time, though now it's widely accepted as an important investment input). A consultant asked us to design a strategy that would be an alternative to fixed income, since at that time fears of inflation were stronger than they are today, and the most basic arithmetic shows that fixed income investments come up short as an investment in an inflationary period. So we studied the Ibbotson review of asset class returns I mentioned above, and became convinced that a high dividend strategy could become a strong competitor to fixed income investing.
JVS: For your Strategic Dividend Index Screen, what makes a company a "quality stock" and therefore qualifies it for inclusion?
LM: Reliable cash flow coverage of a company's obligations… We generally want to see at least 3x-4x cash flow coverage of interest obligations, and 2.0x coverage of dividends. One can't be too rigid -- each business is to some extent unique -- but in general the larger the coverage, the higher the quality. We don't want to own a business that will choke on its debt payment obligations when times or tight, or that will fail to raise the dividend consistently.
JVS: And for the dividend screen itself?
LM: High dividend yield basically means the stock is in the top 4 deciles of yield, where 10 is the highest yield. Actually decile 10 is a bit like a video game with monsters hiding behind rocks -- often stocks with the highest yields are troubled in some way, and get sold down by skeptical investors, producing those high yields. But there are others in decile 10 that are pass-through stocks, such as REITs and MLPs, and these don't pose problems as a group or category. Our investing tends to concentrate in deciles 7,8,9, with pass-through stocks from decile 10. There are a number of reasons for this, but the simplest support for our view comes, again, from the long term data. Deciles 7,8,9 have outperformed the market over the long term, and with less volatility. That's really what you want as a professional investor: better returns with less volatility. If your strategy doesn't provide that combination, or at least better risk-adjusted returns, you might as well be an indexer, because you're not accomplishing anything.
JVS: What sort of dividend growth are you looking for -- just referring to the delta element?
LM: There is always a balance between level of yield, certainty of the dividend, and expected dividend growth. One of our primary interests is in Yield on Original Investment, or Yield on Cost. If your cash yield on cost of a stock is 10% or more, with little or no volatility, you'd not have a good reason to do anything other than hold that stock -- since that's the alleged long-term total return from equities. Since we're long-term holders, we have some stocks that we've owned for more than 20 years, and some of those show Yield on Cost of 30% or more. And as you'd expect, when the dividends have gone up that much, so have the stock prices.
An interesting problem arises: would you rather buy a high-yielding stock with a modest expected dividend increase projection, or a lower-yielding stock with a much higher dividend growth projection. We created a calculator that shows, side-by-side, how soon you will get to a targeted yield on cost from one possible investment versus another. We hope to post this on our website soon. But the answer to the question is that in most cases, you will prefer the higher-yielding stock with moderate dividend growth to the lower-yielding stock with very strong projected dividend growth. It takes the lower-yielding stock a long time to catch up to the yield on cost of the higher-yielding stock; and whether or not by that time the first stock will continue to have very strong dividend growth is a rather open question!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The author is being compensated by Pristine Advisors, a PR and investor relations firm in the investment and CEF industry.