In today's topsy-turvy equity market, dividend investors continue to be challenged on a number of angles. On a macro-level, the ZIRP environment continues to elevate the allure of dividend equity since the largely forgotten fiscal crisis of 2008-09. This has resulted in historically above-mean valuations and consequently, lower than what might be expected yields at today's market prices.
One of the questions investors need to confront is whether this environment proves to be an ongoing secular phenomenon or not. While logic might dictate that interest rates cannot remain continually low, financial markets don't function on logic, they generally function on a combination of macroeconomic/corporate perception and reality.
Those who have been predicting a bond market collapse over the last 7+ years, or have opined a "dividend bubble," opting instead to sit things out in cash, have missed out on a number of levels. Minimally they've missed out on investment grade bond coupons. On the other side of the opportunity cost spectrum has been potentially missed doubling of equity capital and robust dividend growth.
So for the time being, cash hoarders have not had much to brag about. Still, given the early year sell off, there have been opportunities, however short, for investors to get into equity at significantly more attractive valuation. Some dry powder should not be considered a sin, but holding too much of it waiting for Godot may not be a virtue, either.
And despite the fact that market indices continue to hover near all-time highs, there has been a huge dichotomy in corporate performance, which continues to present opportunity to nimble dividend investors focused on value and overreaction.
A Growing Problem
On a stock/sector specific level, investors seeking durable dividends and robust income growth have had other issues to contend with as well. Integrated energy stocks, which have been some of the most dependable of dividend growth vehicles for many decades, have been on somewhat of a wholesale DG freeze since the petroleum rout began about two years.
Time will tell if the recent rally sustains itself or proves more of a dead cat bounce. While I'm more inclined to think the latter, in either case don't expect the Chevrons (NYSE:CVX) of the world to develop renewed DG anytime soon given the severe retooling that has been undertaken.
Elsewhere, consumer products companies, which also tend to be core positions for DG investors, given their robust histories, have seen collective performance that can best be described as mixed. Procter & Gamble (NYSE:PG) has grown its dividend a measly 2% on average over the past 24 months, as it contends with currency translation and generally uninspired performance across its brand portfolio. The company continues to take on utility-like operating characteristics, and performance.
On a more positive note might be McDonald's (NYSE:MCD), which had started to see operating deceleration three years ago. Amidst a management shake-up, mild menu revamp, and introduction of all-day breakfast, Mickey D's seems poised for a higher divvy bump this year. Whether that can be maintained is another question.
Banks and other financiers more dependent on spreads than fees for their bottom lines have also seen the pinch. While banks have historically been viewed as widows and orphans type stocks, the financial crisis has taught us otherwise. Since then, financial stocks in general don't seem to be showing up much in DGer portfolios. Wells Fargo (NYSE:WFC), which seems to be the favorite, announced a token 1.3% bump last month, although that is likely to increase by a somewhat higher sum, but probably nothing stupendous, later in the year.
Bank of America (NYSE:BAC) hasn't raised its dividend in 8 straight quarters. Even growth at PNC, my favorite super-regional play, seems to be slowing to a crawl, amidst weak fee income and generally difficult operating conditions.
A real horror show lately has been retail, although fortunately these stocks tend not to figure prominently in dividend growth portfolios. A whole slew of broad liners including Target (NYSE:TGT), Kohl's (NYSE:KSS), and Nordstrom (NYSE:JWN) have been guiding lower. However, in another dichotomy, the two home improvement kingpins, Lowes (NYSE:LOW) and Home Depot (NYSE:HD) have been hitting the ball out of the park. Whether the broad line weakness is the disruptive Amazon (NASDAQ:AMZN) effect or something more transitory in nature, I'd keep retail on a relatively short leash in terms of overall allocation.
Certainly not everything has been doomsday in dividend land. Some mega-cap tech names have been performing admirably. Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO) have been doing quite well and providing better than average DG. Disney (NYSE:DIS), Altria (NYSE:MO), and Kraft Heinz (NASDAQ:KHC), are other favorites that have had good runs, although Disney seems to be running into a broadcast headwind.
The REIT space on a wholesale level, with a couple of exceptions, has seen steady, if not robust, operating growth. Most of these entities have been able to significantly improve cost of debt and increase unencumbered asset pools amidst the low rate environment. Most learned a valuable lesson during the financial crisis and are in better shape to deal with recessionary environments.
Particularly strong have been the self-storage entities. Triple-net REITs with long contractual lock-ins have also been hot. Seen somewhat as bond proxies, investors bid these stocks up during fearful flight to quality episodes or, more generally, when long rates decline.
The Critical Nature Of Dividend Growth Projecting
While I'm long past the stage of harping on whether someone should be a dividend growth investor or not, if one chooses a dividend growth path there should be comprehension of its analytical limits and a realistic view toward potential within a portfolio.
To an extent, dividend growth seems to be a lagging or ambiguous indicator of corporate health. For instance, Procter & Gamble has struggled to gain revenue/EPS traction for the better part of a decade now. Despite basically flat operations, the company raised its dividend by 7-10% every year between 2008 and 2014. If you had simply focused on dividend growth, you would have missed the point that the company, in reality, was struggling. If you had honed in on its payout ratio, you would have seen the growing problem.
So for the past two years, finally, PG's dividend decision basically reflected the reality of slack to no growth at the company. Had they continued to boost the dividend at even a 7.5% annual rate, the payout might be about 83 percent today. As it stands now, the payout is about 74% of FY 2016 consensus, very high for a C-corp. with growth expectations attached. Ten years ago, the payout was at about 40 percent.
If you are expecting 7-10% consistent DG out of PG today, you'll want to think again. Even if the company ekes out a year of 5% bottom line growth, I would consider it unlikely that the board at this point would issue any increase in excess of operating growth. If anything they may try to bring the payout ratio down, which would indicate less DG than bottom line growth. Pessimistically speaking, PG's next decade might turn out much like the past one, which could mean an end to its impressive streak.
On the flip side of this situation is a company like industrial/tech conglomerate Honeywell (NYSE:HON), which has been increasing its dividend payout intentionally in excess of earnings growth. HON has raised its dividend 15% for the past three years and will probably continue to do so, while earnings have been ramping at about a 10% clip. Despite the rapid growth, the payout ratio sits at about 36% of this year's consensus estimate, only about half of PG's.
Even if Honeywell's earnings started to flat line at the end of 2016, it could raise its dividend by 15% for another two years and still maintain a payout ratio less than 50 percent.
While payout ratio relative to earnings is a reasonable way to normalize dividend health from company to company, keep in mind that certain industries will require higher recurring capex, decreasing their ceiling of reasonable free cash flow payout to investors. You also have business models like REITs and MLPs where funds from operations and distributable cash flow, respectively -- as opposed to earnings -- are a more appropriate means for determining dividend or distribution coverage.
Low Yield High Growth or High Dividend Low Growth?
I suppose this is the $64,000 question for many. Exact portfolio composition is a highly personal matter where both subjective and objective calls need to be made. The lower your investable asset pool, the higher your yield need, and the longer your time horizon, in general, the more sensitive you may need to be about seeking growth. Likely, a 75 year old retiree and a 45 year old working professional are going to have varying views concerning the exact composition and growth requirement of a dividend growth portfolio.
The 75 year old might see a higher yield lower growth strategy as prudent, however if they happen to live another 25 years and either don't attempt to fight inflation or draw down on assets too quickly, being too conservative could pose a problem. The 45 year old with many years ahead might decide to be ultra-aggressive, but could get hit hard during a recession, experience both income and capital destruction, and see an early retirement evaporate as a result. Yes, it's possible that you can be overly aggressive, or overly conservative.
In many, or even perhaps most cases, owning a variable mix of security types is probably the most prudent solution. For every PG that shows slack growth, hopefully there will be a Honeywell to counterbalance that situation. Idealistically, but not realistically, you'll never want to see any stock in your portfolio fall into PG's idle or worse, a Kinder Morgan (NYSE:KMI) reverse.
Avoid The Forever Mentality
I know this view runs counter to many DG purists who advocate, if not pound the table, on never selling "quality" dividend growth stocks. While to an extent this may be understandable, psychological attachment to any investment or an assumption of "once good, always good" hurts one's ability to objectively analyze. I know I am guilty of this myself at times, holding longer than I should out of hope or some other misplaced emotion.
To maximize dividend growth, total return, or any other investment goal, you need to let go of your heart and let your mind do the work. To hold a stock simply because you have an attractive yield on cost or relish monthly dividends in lieu of owning a similar stock growing its dividend much faster but paying only quarterly dividends is not doing yourself a favor. If you're holding because of a huge capital gain, that's one thing -- if you're holding a clearly inferior investment in a qualified account because you "love" the stock, that's clearly another.
I won't belabor the point, since I know many have a quite opposing view on this subject, which I certainly respect, even if I don't happen to agree.
The Struggle For Balance
With the market up another percent on Tuesday and the DOW within striking distance of 18,000 again, knowing whether or where to allocate to equities continues to be a difficult question for not just dividend investors, but just about any investor. Our early year collapse illustrates that stocks are clearly vulnerable, yet low interest rates continue to prop up valuations, as they have for many years now.
The Fed continues to lean hawkish at the moment, but undoubtedly another equity sell off would shift them back into the dove column. Given the unique situation, I don't think central bankers have much conviction in their views and actions anymore.
While there should be acceptance of sell off vulnerability, I don't think you go into hibernation either. I still find folly in the thought that the Fed will be able to raise interest rates with pure abandon. This is a thought echoed by the bond market, with long rates still lower than what they were when the Fed moved 25 basis points 6 months ago.
Despite the expense of the current equity-income forest, there are a variety of trees with attraction for a variety of dividend growth types. Appliance maker Whirlpool (NYSE:WHR) sells at less than 12X this year's earnings and looks to be growing the bottom line by 15% both this year and next. It yields 2.4% and just announced an 11% dividend hike. This is an up and coming dividend growth stock you should keep your eye on in my view.
How about Boeing (NYSE:BA)? Not particularly cheap, but it and Airbus maintain a virtual duopoly in commercial aircraft manufacture. The payout ratio is at about 50%, but yield is 3.4 percent. A cash cow with a balanced share buyback and dividend growth attack.
Rising along the yield chain, there's health care property kingpin Welltower (NYSE:HCN). A recent pullback has the shares boasting a 5% yield, a reasonable 15X FFO multiple, fortress balance sheet, and tremendous growth visibility, albeit not particularly robust. This is a stock where you clearly trade quality of assets and supporting financials for an accepted slower rate of growth.
Finally, on the more speculative end, I'll mention Pattern Energy (NASDAQ:PEGI) an owner of wind power facilities in the Americas. The stock currently yields 7.37% at last payout, while trading at less than 12X 2016 expected cash available for distribution, or CAFD. Pattern has increased its dividend at least 1.9% for each of the last 9 sequential quarters, and current payout represents about 70% of CAFD, lower than average for a YieldCo.
Whatever type of dividend growth investor you consider yourself to be, take the time to understand the limits and potential of each and every stock you own or are conducting due diligence on. Projecting what is reasonably possible, eliminating unlikely scenarios, and acting on reality as opposed to misplaced emotion, can make the difference between a portfolio that comfortably meets forward investment goals and one that falls well short.
Disclosure: I am/we are long CSCO,HD,MO,BA,HON,MSFT,DIS,JWN,PEGI,WHR,HCN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.