Feb 20 2014, 9:20am CST | by Forbes
Who doesn’t love a little something extra—a gift with purchase, a bonus of some kind? Well, in equity investing, those “little extras” can add up to a whole lot.
Investment professionals often talk about “total returns” from stock investments. Simply put, a stock’s total annual return consists of annual appreciation—i.e. how much it went up (or down) that year—and the dividends paid annually.
Here’s the amazing part though. Historically, dividends—the little bonus paid to shareholders—have contributed to approximately half of the market’s total return. Consider this: The historic return on the stock market since 1929 is about 9.5%—half of which can be attributed to dividends, according to Standard & Poor’s.
So choosing a solid company with dividend paying stocks is tapping into all the upside potential the stock market has to offer without having to try to “pick a winner” from unfamiliar companies that just happen to be in the news a lot.
Dividend-paying stocks won’t as a rule provide “explosive” growth, but they can grow and compound faster than inflation (or a CD in a bank).
Here are some I like and their dividend yields.
|Illinois Tool Works (ITW)||2.1%|
|Eli Lilly (LLY)||3.8%|
|Owens & Minor (OMI)||2.8%|
|Southern Company (SO)||4.9%|
What I like about these companies is the strong dividend yield (cash dividend ÷ stock price), a strong balance sheet and, perhaps most importantly, the growth in their dividends. Not only do dividends add to the total return, but dividends that grow over time offer a significant hedge against inflation. To see this look at the chart below that shows the average annual growth in dividends annually from 2003 to 2013.
Average annual growth in dividends 2003-2013
|Illinois Tool Works (ITW)||13.0%|
|Eil Lilly (LLY)||3.9%|
|Owens & Minor (OMI)||15.4%|
|Southern Company (SO)||3.8%|
All of these companies have bested the inflation rate of 2.4% since 2003, some rather spectacularly. Stodgy old McDonald’s, for instance beat the rate of inflation by a factor of nearly 10x. That’s some inflation hedge. Even 102-year-old Illinois Tool Works beat the rate of inflation by almost 5x.
When looking for dividend paying companies, it’s important to pick companies that have the ability to keep paying them even when there is volatility in their revenues or earnings. One way to get at this is to look at the dividend payout ratio (dividend per share ÷ earnings per share). This ratio tells you what percent of the company’s profits are allocated to dividends. The chart below shows these dividend payout ratio for our favored companies.
Dividend Payout Ratios
|Illinois Tool Works (ITW)||42.6%|
|Eil Lilly (LLY)||45.4%|
|Owens & Minor (OMI)||54.9%|
|Southern Company (SO)||107.5%|
Intuitively, it’s easy to understand that a company that pays 90% of its profits in an annual dividend totaling, say, $1.00, will have trouble paying its dividend in a year when revenues or profits decrease by 25%. By contrast, Microsoft, shown in the chart above, uses just 36% of it’s profits to pay its annual dividend of $1.02. Should revenue or profits decline at MSFT in any given year, the company has plenty of “cushion” to continue paying it’s shareholders $1.02.
Note the Southern Company dividend payout ratio of 107%. That means if profits are $1.00, the annual dividend is $1.07, a seemingly unsustainable payout. However, as a utility, Southern Company has lots of depreciation, which is counted as an expense, but does not really use cash. When looking at the cash flow of Southern—which is different from profits—I feel the company can continue to pay a dividend without interruption.
There are plenty of great companies out there that pay a good dividend and have a track record of increasing them over time. The ones shown in this article were chosen for our “Dividend Buster” portfolios for their dividend track records, as well as strong balance sheets too, which will help keep investor’s cash flows strong, even when the economy gets choppy.
Source: Forbes Business
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