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Ride the Retiree Wave with Dividends
Wednesday March 29, 6:00 am ET
By Josh Peters, CFA
It's no secret what's about to crash onto the shores of the American economy. Rather than working for money, the massive baby boom generation expects to have its hard-earned money work for it.
At the same time, another megatrend is rolling through corporate America. Despite all-time record profits, big business isn't investing in new factories, stores, and workers the way it usually does--and the cash is piling up.
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If this sounds like a dream scenario for dividend investors, well, it just might be real. We're certainly focusing on these trends in Morningstar DividendInvestor, which I edit. (Click here for more information, including a free trial subscription.) But we can't just buy any dividend-paying stock and expect the newly retired to run it up; a lot of traditional income sectors like real estate investment trusts and utilities are already expensive. If we're going to ride the wave from here, we need an unconventional strategy:
1) Buy dividend potential, not just current yield
2) Look for unconventional sources of income
Demand Side: Pay Up or Get Dumped
In the effort to sustain their standards of living, the 80 million boomers face unprecedented challenges. As a group, they haven't accumulated enough savings in their working lives. Long-term interest rates remain low, compounding the challenge of extracting sufficient income from nest eggs.
Are stocks the solution? These retirees already own a huge chunk of the market's wealth. While the bull market of 1981-2000 added handsomely to their assets, the bear market of 2000-2002 taught these folks that touch-and-go capital gains can't be trusted to provide regular income.
But there's good news here. While companies in the S&P 500 paid $200 billion in dividends last year, they earned $700 billion and generated something like $500 billion in free cash flow. The market's yield, though higher at 1.9% today than it was five years ago, remains too low to fund retirees' need for income.
One way or the other, the stock market's yield has to go up. One way would be to see the boomers dump their stocks in search of income wherever it can be had. Since falling prices instantly translate to higher yields, that'd be one way to solve the problem. But faced with the prospect of a widespread dumping of stocks, corporate America may have little choice but to take payout ratios substantially higher.
Supply: Means and Motive
The good news for retirees--and all investors--is that the corporate sector has ample means to pay higher dividends. The payout ratio--35% for the S&P 500 at the end of 2005--is as good a place to start as any, and it is substantially below the market's long-run average of 50%. Bringing today's payout ratio up to historical norms implies a yield on the S&P of about 2.5%.
Yet the market payout ratio plays only one part in my case. Looking out across the myriad of shifts in the economy over the last few decades all points to more cash for dividends:
Falling capital intensity. The American economy isn't the world's metal bender the way it once was. Think of the giants of U.S. business in 1950-- U.S. Steel (NYSE:X - News), General Motors (NYSE:GM - News), AT&T (NYSE:T - News), and the like. Expanding productive capacity to keep up with population and rising incomes forced massive outlays of cash for steel mills, assembly plants, and copper wires. As a result, the net cash content of reported earnings from the 1950s to the 1970s--free cash, of course, being what investors are really interested in--was much lower than it is now. Today, with knowledge-based standard-bearers like Microsoft (NasdaqNM:MSFT - News) and Johnson & Johnson (NYSE:JNJ - News), American industry doesn't need to reinvest nearly as much of its reported profits to support growth.
Rising returns on equity. Conventional wisdom (among economists, anyway) suggests that when returns on corporate equity are high--as they are today, I estimate 18% for the S&P 500--companies have an incentive to reinvest and grow faster. But faster reinvestment by business doesn't necessarily accelerate growth; more likely, it depresses returns. With today's returns on equity so high, future growth is less costly to fund--again, leaving more cash available for dividends.
Realignment of management incentives. None of the above would matter much if CEOs were only oriented toward earnings growth. But no longer do you find most CEOs compensated on the basis of sales or earning per share growth alone. Much more often, you'll find performance evaluated on the basis of return on invested capital (or ROIC, a close cousin of return on equity), profit margins, and free cash flow. And if high returns and cash flow are what is incentivized, that's what most managers are going to deliver. If you doubt this, check out the amazing results from AutoZone (NYSE:AZO - News), one of the earliest adapters of an ROIC-driven compensation plan. AutoZone doesn't pay a dividend yet, but I'm willing to bet it eventually will.
An increasingly payout-friendly tax code. When marginal tax rates for dividends and capital gains were very high, it made sense to retain as much profit as possible, using those funds to invest and increase earnings, which would then be passed on to investors via long-term unrealized (tax-deferred) capital appreciation. But as you reduce the tax rate on the cash corporations pay out to investors, the incentive trends in favor of paying out more.
Any one of these factors might not motivate greater free cash flows or higher dividend payouts. But put together, they're practically a landslide shift in favor of dividends.
Riding the Wave
Investors' newfound preference for income is already in evidence--just look at the massive runup in prices for utilities and REITs in the past few years. Yet not every dividend-paying stock--even those with high yields--stands to benefit from the trends I've just discussed.
For example, I can't see most utilities stocks riding this wave. Most of their yields are already below those of long-dated Treasuries. And with the industry already paying out 65% of earnings and well over 100% of free cash flow (underscoring how much it costs utilities to grow), there's not much room for stepped-up payout ratios. Exceptions exist, but as a rule, they're already giving about all they have to give.
I'd rather spend my time on companies with high free cash-flow yields but still-modest dividend payouts. Take Illinois Tool Works (NYSE:ITW - News), a superb industrial manufacturer. ITW is obviously committed to its dividend--it's raised it 43 years in a row--but despite a free cash-flow yield of 6%, it paid out only 25% of that cash through dividends in 2005. Better yet, its return on equity of 19% over the past 10 years suggests ITW could pay a significantly higher dividend and still obtain good earnings and dividend growth.
I'm also on the hunt for firms with big buyback programs that could be diverted to dividends instead, like newspaper and TV station owner Gannett (NYSE:GCI - News). Gannett's current yield is only 1.9%, but its free cash-flow yield is more than 8%. For years, the company has spent most of the difference on share buybacks, but since early 2004, the stock has done nothing but drop. It's a first-rate media property, and while we're a bit wary of management--it currently earns a Stewardship Grade of "D"--we might consider a major increase in the dividend to be a sign of improving governance.
I also like the prospects for well-chosen master limited partnerships (MLPs). They offer high, sustainable, and growing yields, yet investors haven't wanted to own them in the same quantities as utilities and REITs. One of the perceived barriers to ownership is tax complication (a legitimate concern), but I also think investors fail to appreciate the growth potential that a Kinder Morgan (NYSE:KMP - News) can offer compared with other high-yield stocks.
And in the long run, buying undervalued stocks is the best route to higher total returns. Investors still aren't looking to bank stocks for income, even though the average yield of the six banks we recommend in the DividendInvestor Portfolio (4%) is greater than the average U.S. utility Morningstar covers (3.4%) and not much less than average REIT (4.5%). At some point in the next few years, the yield curve will normalize, earnings growth will accelerate, and the retiree-driven market will wake up to the outsize income potential of large-cap banks.
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