As the stock market gets more heated (some say overheated), investors are increasingly wondering what role dividends and buybacks might play in their future. According to a Standard & Poor’s paper, dividends contributed about a third of the monthly total return of the S&P 500 from 1926 to 2012. In the ’40s and ’70s, it was more than half.

The nadir was the 1990s, when the corporate culture of benevolence was tapped out and growth companies decided to use their cash in other ways. Since then, dividends have roared back, especially since the financial crisis. For long-term investors, the effects of dividends are largely seen in the total return over time. The S&P 500 Dividend Aristocrats Index, made up of companies that have increased their dividends every year for the last 25, has beaten the regular 500 index for the past five years, winning 18.41% over the latter’s 16.91%, while over 10 years the total return was 10.61% and the S&P 500’s was 8%.

Purists like dividends because they show a company is correctly deploying its capital (not letting cash sit on the books making bupkes), and also because the companies are demonstrating the reliability of their earnings and proving they love shareholders enough to pay them back. But in the last few years, investors have come to love dividends for other reasons. At a time when bonds have been yielding close to zero, a horde of retired workers have been looking for new ways to juice cash off their investments the way they did bonds in the ’80s and ’90s. Dividends also offer a firewall against market downturns; they make plummeting share values more innocuous. In fact, Goldman Sachs reportedly suggested in a note to clients that dividends and buybacks, set to return $1 trillion in 2015, would provide the market’s entire upside.

This search for yield has bid up the price of companies with higher payout ratios, says Don Taylor, lead portfolio manager of the Franklin Rising Dividends Fund, who has a chart breaking payers in the S&P into quintiles and showing the high P/E names have flipped to favor the good payers.

“This is dramatically different from 15 years ago,” he says. “At that point, if you were paying dividends, you were considered a company that couldn’t grow and didn’t have much value. It’s also a reflection of the very low interest rates and this search for something to generate an income stream when traditional quality fixed income has hardly any.”

But he warns that not all dividend payers are equal, and the purists, again, have distinguishing tastes and hair-trigger tempers. Josh Peters, of Morningstar, who runs its model Dividend Select Portfolio, says of tech companies, “No more.”

“If anything, I’ve been moving in the opposite direction over time and clinging more tightly to the tried and true,” Peters says.  

Taylor says that it’s the low interest rates that have gotten dividend stocks’ values ginned up, and that at the highest yield levels, they are behaving like bond proxies. That’s a risk if interest rates rise.

For that reason, Taylor says his fund’s strategy is to focus not on dividend yield per se but only on a dividend’s growth over time. The question: Have the dividends been rising steadily by 10% or so per year for many years, and can that be sustained?

That’s why many managers in this spot start with a lower payout ratio, a yield of 1.5% or so, where there is room for the dividend to grow and attract shareholders. It means seeking favorably positioned companies with steady earnings growth rising in stately pace and dialing up 6% to 10% dividend increases a year consistently without hiccup (that 1.5% yield, not impressive at first, becomes much more so—4% and higher—in 10 years or so).

One company Taylor likes for that reason is Becton Dickinson, a medical device company well known for, among other things, its innovations in needles and syringes, Taylor says. It has cranked up its dividends 43 years in a row. “We first started buying it in late 1996 and owned it ever since.

“At that time, it had 24 years in a row of dividend increases and the annual dividend over the previous 10 years had increased from 8 cents to 23 cents. So that’s a pretty substantial increase. The stock was trading at $19, so there’s been a 1.2% yield.” Not high, but “they’ve had annual dividend increases every November, so now … 43 years in row, the annual dividend is now $2.40, up from 23 cents in the fall of 1996.” That’s a double-digit compound dividend growth rate, he says. If you take $2.40, divided by the $19 price it was when the firm established that position, that’s 12.6%.”

His fund also likes Praxair, an industrial gases company spun off from Union Carbide in 1992. Since becoming independent, the business has increased its dividend every year.

Taylor says he’s looking for the dividend growth to come from predictable topline cash flow growth, not because the company has excessive cash on the balance sheet and just wants to scrape it off the books. “It only works for the long-term if the business can consistently grow.”

Apple, he notes, is one company that had too much cash for too long doing nothing. He says tech companies have come around to dividends, but belatedly. “We own Microsoft. They have more than a 10-year record of dividend increases.” But he adds, “They should probably have more than a 20-year record.”

Brave New World
Tech companies, once the stingiest of corporations when it came to paying back their shareholders, have now become more shareholder friendly—and after a decade or so of virtue, they are migrating into the portfolios of dividend managers, who are newly confident about these prodigal payers’ willingness to shell out after getting nudges from activist investors and building 10-year track records of dividend growth. In April, Apple raised its dividend to $2.08 a year, an 11% increase, which made it the biggest dividend payer in the S&P when measured by total dollars distributed to shareholders, according to Bloomberg.
That would make it a plum play for dividend investors, it would seem. The company had $193 billion in cash, according to its April 2015 10-Q.

So the world has changed, right? Not enough to convince Peters at Morningstar. He says he’s been burned in the past by companies that have promised hefty dividend payouts, only to cut them when there is trouble. That’s made him gun-shy about Microsoft, Apple and Intel, none of which he currently owns. He even got rid of Intel when it was throwing off lots of money and about to go off on a price surge.

“With [Intel’s] dividend up 6.7% this year, selling in early 2014 was a mistake,” Peters wrote in Morningstar’s Dividend Investor newsletter. “But unpredictability/cyclicality highlight difficulty finding reliable [dividends] in tech.”

To Financial Advisor, he says, he was for a time a bit more open minded. “The way I look at a company like a Microsoft or an Intel or a Cisco, these are not growth companies anymore. What are they? They are cyclicals. They are kind of curious cyclicals in that they have still pretty high profit margins and high returns on capital and giant hoards of cash that you don’t find among, say, a GE or a UBS or more traditional industrial/cyclical types of businesses, but you still have exposure to economic cycles.”

That doesn’t augur well for sustained payouts in a possibly stagnant business, especially like PCs in the tablet and iPhone era. Microsoft increased its dividends plenty over the years so that its yield rose from a low 1% area to a solid 2.5% only 10 years later, yet Peters asks, “What is becoming of all of the cash that they aren’t paying out as dividends? Is it benefiting you as a shareholder or is it just piling up in idle offshore accounts or is there the risk that they go on to make a bunch of acquisitions that destroy shareholder value?” He, too, suggests the dividend could have been two, three or four times what it has been.

Casey Sambs and Kenneth Conrad, portfolio managers of the BMO Dividend Income Fund, say they’ve been managing a dividend-focused strategy for separate accounts since 2002 and their mutual fund for three years. Their strategy looks for undervalued companies from the S&P with a dividend yield of greater than 1%, and the goal of the entire portfolio is to have a dividend yield more than 1% higher than the S&P 500 (which is about 2%).

The fund had 79 stocks as of May but usually has 55 to 80, and it keeps band constraints around the sectors so that all of them are represented. Even though the fund is tilted toward utilities and telecom as staple dividend payers, “it’s changed over time because there is a larger opportunity set,” says Sambs. “Over the last 10 years, our investable universe has expanded by 35% given the number of companies that have initiated or grown their dividends.” That means tech is now one of the largest sectors.

Sambs and Peters both say that it’s sometimes good to hold on to companies going through problems if they are consistent payers, not only because they are dedicated to paying, but because a higher yield in a diversified portfolio is hard to replace and can offset current lower yielders, allowing you to nurture the ones set to grow.

Sambs says some telecom companies like AT&T’s and Verizon’s price war has made investors nervous about their stocks, but they both pay well (the latter has a 5.5% yield and Verizon has a 4.4% dividend yield). “The nice thing is that their yield allows us to own other companies that might have better total return prospects in the near term”—perhaps a consumer discretionary company with lower yields that is going to benefit from declining gas prices.

Peters, in similar fashion, is holding on to GlaxoSmithKline, a drugmaker with some pipeline problems whose share price has plunged and dividend yield subsequently risen to 5.2%. The firm has recommitted to a dividend through 2017, but there is no margin of earnings safety to cover it, Peters says.
“I’d like to own something else,” he says. “The question is, how do I replace that income stream?”

Financials, despite their drastic dividend cuts after the crash, are still big parts of people’s portfolios. John Schmitz of Bahl & Gaynor in Cincinnati, Ohio, says the banking sector has had a dividend growth resurgence of sorts after its 2008 cuts, but the yields are still below where they were. “You also have more of a regulatory issue with their growth prospects because of capital requirements, payout ratio levels. However, they are better situated than they were 10 years ago. They have better capital, they have better balance sheets, they have better loan quality.”

Besides that, banks will benefit if interest rates go up—as they will, inexorably from the subzero troughs they’re in now.

Ben Kirby, the co-portfolio manager of the Thornburg Investment Income Builder Fund, says dividends around the world are increasing and more companies are paying them, seeing them as an attractive way for companies to boost their stock price, in some cases by using debt to fund it. The Thornburg fund is a global portfolio that buys stocks and bonds to build income, but bonds have fallen from a quarter of the fund to about 9% because of their lower income. That’s put a focus on dividend payers. The fund is looking to companies with ample free cash flow and willingness to return it to shareholders.

“By region, we’re more optimistic on Europe than the U.S. Valuations in the U.S. are relatively high, are relatively stretched.” Emerging markets make up 15% of the fund. (The U.S. makes up 50%.)
 
Different Strokes
Not everyone plays yield the same way.  “There are only two things with certainty that you can value, in our view,” says Mark Eveans, president and CIO of Meritage Portfolio Management. “One is sales. The second thing is dividends. They are a hard cash payment. What we would say is that earnings are kind of a guess. Dividends are a certainty.”

The managers at Meritage, a boutique institutional manager with $1.5 billion, start with finding the best yields for its 12-year-old “Yield Focus” strategy, in which it runs about $300 million. A big component of the view is a company’s free cash flow. The aim of the yield focus strategy is to earn at least 60% to 70% of the expected equity return over 10 to 12 years in cash payments. The minimum yield the firm looks for in a candidate company is 3.5%, which boils down to about 1,000 companies from its 7,000-company database, which then get boiled down further to 45 to 60 portfolio picks.

“About 65% of those exist in United States companies and 35% internationally,” says Eveans. About a third of the portfolio comprises things other than common stocks: REITs, LPs, MLPs, convertible and straight preferreds and business development companies. Though the Yield Focus group is just one of the firm’s value strategies, Eveans says it’s been the best performing.

“We want to earn twice what the S&P pays or any other major market index or for that matter, most of the dividend strategies available on Wall Street; we want to earn twice what they’re paying right up front. That’s a 200 to 300-basis-point advantage that we go into each and every year with in terms of earning return.” Financials, including REITs, make up about 31% of the portfolio, while energy makes up 13% and utilities make up 11%. The company has made a major shift to international within common stocks, where it sees more opportunities with value and yield.

One area he says is starting to look tempting is European banks. Because of regulatory hamstringing, they have been making fewer bad loans and they are overcapitalized, Eveans says. That has led to free cash flow excess. Meanwhile, those banks’ valuations are still good because of the bad economic environment in Europe. He also sees good payers among banks in Canada and Australia, which didn’t have the same financial contretemps the U.S. and Europe did, and which are well capitalized and able to grow their dividends.

National Australia Bank (whose gross dividend yield is 8.83%) and Canadian Imperial Bank of Commerce (with a 4.3% yield) both fall into the top 15 holdings in Meritage’s Yield-Focus Equity fund.

Kirby at Thornburg is circumspect about those stocks that just focus on high yields. Those that pay 5%, 6% over time are probably going to behave more like bonds, he says. “If your companies aren’t growing, the stocks are going to behave and they are going to look very much like bonds. So a stock that’s paying 5% but not growing looks an awful lot like a bond paying 5% and in that case you don’t really have the ability to preserve purchasing power over time.”