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Alternative Bonds...With Unlimited Upside

Jan. 14, 2011 1:57 AM ETCAT, MCD, PG
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My previous article explained my negative outlook for the bond market, and also promised an alternative to fixed income. As I'm sure you have guessed the answer is dividend stocks. The proper approach can provide the reliable income associated with bonds and also the unlimited upside characteristic of equities. This article will delve into the process for choosing suitable equities to replace and/or augment bonds in your portfolio. 

According to Robert Shiller, the current dividend yield of the S&P 500 is 1.74%. Now I know you're saying, "That's only half the yield on the 10-year T-Note!" That's true but consider the growth rate of dividend payouts for several blue chip firms: CAT, MCD, and PG.

In a span of ten years each of these firms substantially increased nominal dividend payments. This means an investor is continually improving his or her cost basis dividend yield. For example, buying $10,000 of MCD stock (282 shares @ $35.47) ten years ago would have meant a dividend yield of 0.65% ((annual dividend payment of $0.23 x 282 shares) / initial investment of $10,000). This yield is nothing to write home about. However, over the course of ten years the dividend had a compound annual growth rate of 25.64% which equates to a cost basis dividend yield of 6.37% ((annual dividend payment of $2.26 x 282 shares) / $10,000). On top of this fantastic dividend growth, the investor also enjoyed share price appreciation. At the end of ten years, the investor would have a healthy profit of 135% after combining capital gains and dividends. A CAGR of 8.9% for a security with bond-like payments is a great alternative to fixed income. Obviously this strategy cannot be implemented overnight, but with proper planning and thorough analysis this strategy can blow the 3.3% 10-year T-Note out of the water.

Dividend & Capital Gains Returns
CAT 3.42% 8.64% 9.71% 56.05% 373.83% 428.88% 18.12%
MCD 0.65% 6.37% 25.64% 26.69% 104.88% 134.56% 8.90%
PG 2.03% 5.30% 10.07% 39.27% 84.61% 123.88% 8.39%

While I believe the risk/reward trade off of this strategy is acceptable, there are several arguments against it. The most obvious is that by investing in equities the investor is taking on more risk and putting his or her capital in a position where it could lose value. I will not argue that there is potential for loss, but this necessarily means there is also the opportunity for larger gains because the risk/return relationship always holds. Additionally, when a long term investment horizon is employed, the risk of loss is further reduced. Since 1935 there have only been four negative rolling ten year periods. When the time period is expanded to twenty and thirty year rolling periods, there have been no negative returns for the S&P 500 index since 1935. Of course, the S&P 500 was used a proxy for comparing equity returns, but that doesn't mean every single stock will follow this pattern. However, there are steps one can take to help avoid the stock of poor companies.

Two simple metrics can be used to screen for stocks with potential to increase dividends: 1) free cash flow (FCF) and 2) payout ratio. A firm that kicks off a large amount of FCF is very flexible. The company can pay down debt, grow through acquisition, fund capital projects to increase future cash flow, buy back shares, or increase dividend payments to shareholders among other things. Payout ratio is important because it is an indication of the sustainability of the dividend. It is derived by dividing the cash paid to shareholders in the form of dividends by net income. Anything over one means that the firm is paying out more than it is earning in profits. If a company has a payout ratio over one it is very likely that the dividend could be cut or discontinued which will have an adverse impact on the share price. I usually like to see payout ratios under 75%. Two industries that are exceptions to this rule are REITs and utilities. Companies in these industries typically have higher payout ratios due to the nature of their business and the more regimented fashion of revenue.

The table below illustrates the FCF strengths of the companies outlined above and also shows reasonable payout ratios. All three of these companies were cash machines back in 2001 and continue to generate a great deal of FCF today.

FCF & Payout Ratio
CAT $1.3B 44% $4.0B 45%
MCD $0.8B 18% $3.8B 51%
PG $3.3B 66% $13B 43%

For the investor who has decided it is wise to avoid bonds, the long term commitment to finding great companies with a history of increasing payouts to shareholders can reap dividends. The investor is not subject to the same interest rate and inflation risk as bondholders, and can enjoy growing dividends coupled with the potential for substantial share price appreciation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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