Back in March 2008, Dick Dahlberg, who managed the Columbia Dividend Income Fund at the time, told this magazine that the bank stocks investors craved for their high-dividend yields were going to have a hard time maintaining or increasing their dividends as their financial positions weakened. Instead, he favored stocks in health care, consumer staples and other sectors he felt had more reliable free cash flow to keep dividends afloat and to weather a market storm.
When that storm hit later in the year, no corner of the market was spared. But by trimming down bank stocks and sticking with dividend payers that had better cash flow and stronger balance sheets, his fund managed to avoid the S&P 500’s 37% drop (it fell by only 28% during that challenging year).
Scott Davis took that lesson to heart when he became manager of the Columbia Dividend Income Fund in 2013 after his mentor Dahlberg’s retirement. (He’d been co-managing the fund with Dahlberg since 2001.) Davis and his current co-managers, Michael Barclay and Peter Santoro, believe the highest-yielding stocks—or those that have been paying dividends the longest—aren’t necessarily the best ones for investors.
Instead, the three focus their search on companies with the healthiest levels of free cash flow to identify attractively valued securities and forecast a company’s potential dividend actions. The income produced by the dividend-paying stocks of financially strong companies in their portfolio is also meant to provide some downside protection when the market trends lower.
The focus on high-quality companies with above-average dividend yields “has kept the fund out of trouble, especially when less reliable firms cut dividends when their fundamentals weaken,” noted Morningstar analyst Gretchen Rupp in her review of the fund. “Although this fund can trail its index when markets accelerate, it doesn’t usually fall too far behind and has captured about 96% of its bogy’s gains in months when the market has gone up.”
Some stocks in the portfolio, such as Johnson & Johnson, are no strangers to common high-dividend stock lists. It’s a longtime favorite of Davis, who estimates J&J will generate $19 billion in free cash flow this year. Others, such as global semiconductor giant Broadcom, might be relatively new to the dividend game but have strong cash flow and good potential to maintain or increase those payouts.
In addition to having strong cash flow, companies in the Columbia fund must appear committed to maintaining or increasing dividends and using cash judiciously. “Using cash for stock buybacks isn’t necessarily a bad thing,” says Davis. “But it can also be destructive when companies do it at prices that are substantially above accretive value.” A number of energy companies that engaged in aggressive stock buyback programs in 2015 and 2016 made that mistake, he says. So companies pursuing buybacks must have a consistent, clearly articulated policy for doing so and sensible price targets.
While dividends have played an important role in total return for both the Columbia fund and the stock market, their importance varies over different time periods. Since 1930, the S&P 500 has had an average annualized return of 9.6%, with dividends accounting for some 40% of that. But in the bear market of the 1970s dividends made up 72% of the return. On the other hand, in the upward trending markets since 2010 dividends have only accounted for about 17% of total return.
Davis points out that when the stock market dips or meanders, dividends become a more important component of total return. Just as important for the fund, investors flock to higher-quality stocks in tough times. “The long bull market has made a lot of investors complacent, and index investors have gotten used to doing well in bull markets,” he says. “But with market valuations so high, this is a good time to be getting more selective.”
But rising interest rates are casting a looming shadow, since they can harm dividend-paying stocks by making bonds relatively more attractive. For most of 2016, the dividend yield of the S&P 500 exceeded the yield on the 10-year U.S. Treasury. The opposite has been true since the November election, as yields on the government bellwether have risen while the yield for the equity benchmark has fallen.
Davis points out that even if interest rates rise, dividend-paying stocks will remain attractive because they can increase their payouts to keep pace with inflation, unlike bonds. “I don’t think a mild increase in interest rates is going to present too much of a problem,” he says.
Earlier this year, a report by Sam Stovall, the chief investment strategist at CFRA, also suggested rising rates were OK—but only if there weren’t too big a gap between stock and bond yields. Since 1953, stocks have fared well behind an advancing bond yield, rising an average of 11% and posting price advances 79% of the time when the 10-year bond yield exceeded the S&P 500. But that only happened when the bond’s yield was less than 1 percentage point higher than the S&P’s, showing how close the two must be. “Even though stocks will eventually slip in price, it won’t likely be due to a shrinking yield, so long as it remains competitive with the 10-year note,” Stovall concluded.
Cash Flow Leaders
Using the Russell 1000 as its stock universe, the Columbia fund starts the investment process by zeroing in on the top two quintiles of companies with free cash flow, which history shows have the best potential for dividend growth. The screen eliminates companies that have very high dividend yields but will not likely have the financial strength to support and increase them. The 2.68% portfolio yield of the fund (before expenses), higher than the 1.97% yield for the Russell 1000, reflects the managers’ mission to find stocks of financially solid companies with sustainable above-average dividend yields.
The fund holds between 70 and 100 stocks, with a targeted maximum position of 3%. It can deviate from sector allocations, but strays only within set parameters to avoid big benchmark tracking errors. It currently has an underweight stance in information technology, health care and consumer staples, and it’s overweight in financials and consumer staples.
The fund often underweights technology stocks because many of them don’t pay dividends, according to co-manager Michael Barclay. Once they do begin paying dividends, however, “they can become some of the best opportunities out there because we often see quick and large percentage increases once they start. But we have to be comfortable with their free cash flow, business model and commitment to paying dividends,” Barclay says.
Fund holding Broadcom became part of the portfolio in December 2016, after the company had been paying dividends for about a year. “Before we initiated the position, we met with senior management to discuss their philosophy about capital allocation and confirm that paying dividends is a priority for them,” Barclay says. The managers were also encouraged by the company’s debt restructuring program that converted bank loans to more predictable bonds.
Barclay also cites Microsoft as a strong holding in the technology sector. Since Satya Nadella took over as CEO in 2014, the technology giant has been focusing on recurring revenues from cloud-based offerings rather than less reliable licensing fees.
High valuations in a company are not necessarily a deterrent to the Columbia managers, as long as they can see a clear path toward further growth. Such is the case with fund holding Philip Morris. Even though the stock is a member of the expensive consumer staples category, co-manager Peter Santoro believes the company’s innovative new smokeless cigarette, called Iqos, has the potential to expand sales dramatically.
Also called HeatSticks in some markets, these products have a look and feel similar to traditional cigarettes. They do not burn and are used in conjunction with a controlled heating device. With this “heat, not burn” technology, the levels of harmful chemicals are significantly lower than those of cigarette smoke, according to the company’s website. “With over a billion smokers globally, the launch in 25 countries is only the tip of the iceberg,” says Santoro. The stock has a generous 3.7% dividend yield.
Home Depot, another stock Santoro likes, has had “exceptional and consistent top-line growth” in the home improvement sector. Other factors supporting the stock include the strong underlying growth in the home improvement sector, low mortgage rates supporting the housing industry, and a business that is difficult to replicate. “These factors provide a big runway for Home Depot over the next few years,” he says.
With a turnover ratio of 25%, about half that of the Columbia fund’s Morningstar peers, it’s clear the fund is faithful to its picks. But Davis and his team aren’t afraid to weed out a stock when free cash flow falls into the bottom two quintiles for that metric and prospects for improvement within a year or so are murky. They did that late last year with longtime holding General Electric as its deteriorating cash flows hit the company and the firm’s analysts struggled to find a way the company could reverse the trend.
The stock’s removal reflects a philosophy that has helped keep the fund out of trouble when dividend cuts hit the scene. “A lot of dividend strategies focus first on yield,” says Barclay. “We think it’s more important to look at how well a company is prepared to sustain and grow its dividend over time.”