Some basics of dividend investing

Should a portfolio include dividend paying stocks?  What role do dividends play in an overall portfolio strategy?  How should an investor go about choosing dividend payers?  Today's post will attempt to shed some light on this corner of the market - but first, a short survey for you to share your thoughts:

"Dividends" - the word has trickled out of the investment arena into our general language and shows up when people talk about any kind of choice that "paid off": the NFL draft pick that now "pays dividends", the college degree now "producing real dividends"...the general idea is that dividends are the result of a smart investment.

Originally, in the investment world, dividends were the primary source of return.  An investor buying a share of a company is technically entitled to a share of future profits, and dividends are the mechanism for returning those profits to investors.  If the company realizes a $1 per share profit, they may pay out $0.50 per share to investors and "reinvest" the other $0.50 into the company seeking new growth.

Over the years, the market evolved to include a wide range of management styles, and many companies either greatly reduced or eliminated dividends, instead focusing almost entirely on growth and allowing investors to "choose their own return" by buying and selling shares in the open market and realizing their profit or loss as a capital gain/loss.

In recent years dividends have come back into vogue: a combination of relatively large cash hordes on corporate balance sheets and relatively low interest rates in the bond market has pushed the investing community to look for "income" style investments.  But should investors choose dividend stocks at all?  Which ones are appropriate?  And how does an investor grapple with the very real warning: "all dividends are not created equally"?

At DRW Financial, we do employ a dividend stock strategy as part of a greater asset allocation model, and for a variety of reasons.  The foremost reason:

A consistent and diverse stream of cash flows adds stability and flexibility to the portfolio.

Secondarily, interest rates on traditional fixed income instruments (Bills, Notes, and Bonds) have fallen to a point where their effectiveness within an asset allocation strategy is reduced (not eliminated, but much reduced).

Thirdly, many large and healthy companies do have a considerable amount of cash on hand, which suggests a number of things about the market, but also leads this adviser to believe that (some) dividends may be a more predictable source of decent returns over the next few years.

Below we will discuss some very basic analytical tools for considering a particular dividend stock, but first the requisite and appropriate disclaimers:

DRW Financial holds positions in two of the stocks discussed below, Miller Industries (MLR) and Caterpillar Corp (CAT) in a number of client accounts and in David's personal account.  We may elect to add to this position or sell out of this position at any time and for a variety of reasons.  The discussion in this post about dividends and investments is neither a solicitation nor recommendation to buy or sell a particular security.


So, with that out of the way, let's consider two companies and their dividends.

CAT data by YCharts

Caterpillar and Miller Industries are both makers of heavy equipment; CAT makes construction equipment and tractors and Miller is primarily concerned with large towing and recovery trucks.  The companies' presence in the financial markets are pretty different: Caterpillar has a current market cap of around $55 billion on revenue of $63 billion (last twelve months), while Miller sports a market cap of ~ $180 million on revenue of ~ $330 million.  Put another way, Miller's market cap is about 3.3% of CAT's, so the two are entirely different scales of business.  Company size and market cap can be pros or cons for investment decisions; in terms of the discussion around dividends, we may lean a little more towards considering huge companies dividends as a little more secure, but the final judgement requires more analysis.

Based on the current market price and assumed dividends (***dividends are always at the discretion of management and may be changed at any time***), the current dividend yield for Caterpillar stands at 2.85% and for Miller at 3.49%.  Given only that metric, the choice seems obvious, right?!  But let's look at a couple of additional numbers: the "payout ratio" and the history of dividend payments.

The payout ratio shows how much of the company's available cash earnings are distributed to shareholders.  Remember the example from way above?  The company that made $1 per share and paid out $0.50 would have a payout ratio of 0.5 (or 50%).  Caterpillar's ratio is ~ 0.35; here is a 10 year look at their historical payout ratio as well:

CAT Payout Ratio TTM data by YCharts

Apart from that spike in 2010, the ratio has stayed relatively constant between 25 and 35%.  Because of the way ratio math works, the numbers can swing considerably based on either or both of the factors: the amount of the cash dividend paid or the amount of total cash available.  In very general terms, a lower payout ratio would suggest a healthier or safer dividend, as the company has more cash available as a "buffer" against a future inability to pay.

For contrast, Miller's payout ratio today stands at ~ 0.69.  They do not have a long history of paying dividends, so the historical chart does not offer much guidance.  What we can see is that the company is paying out the majority of their net earnings (nearly 70%!) to shareholders at present, and only retaining ~ 30% to invest in new growth.  This suggests to this adviser that the dividend is relatively less safe...a contraction in earnings could force the management to lower the dividend and/or force them to spend down cash reserves.

And speaking of cash reserves...while the primary source of dividend payments should be ongoing income from a company's operations, there may be instances where a company did really well over a number of earlier periods and has "extra" cash on the balance sheet that could cover dividend payments in leaner times.

Doing a quick check of the total dividend cash paid out versus the total cash on the balance sheet can provide another measure of "safety" for the dividend.  Miller has approximately $47 million in cash and short term investments on hand, versus an aggregate dividend payment of $6,300,000.

Caterpillar has right at $6 billion in cash and short term investments, versus an aggregate annual dividend payment of $1.58 billion.  In both cases, the companies seem to have a good deal of cash on hand relative to the sizes of their business.

It's a lot of data to consider (and this is only a much reduced, simplified look at the math), but should provide some insight into the analysis involved in judging dividends.  To summarize, here is a (simplified) set of parameters we consider and screen against when evaluating possible dividend paying investments:

• current dividend yield (in 2013 we have been screening for yields between 1% and 4%)
• history and stability of dividend payments
• payout ratio (prefer a ratio that looks more sustainable, say less than 0.50)
• strong cash position on balance sheet
• consistently profitable companies

Our conclusion, solely in terms of the safety of the dividend payment, gives the edge to Caterpillar: the lower payout ratio suggests more flexibility and redundancy of coverage, the lower dividend yield suggests the market is discounting the dividend less on a relative basis, CAT has a long history of paying a dividend, and they are a consistently profitable company.

Thanks for sticking around to the end of this post - it got longer than I intended!