Income generators: how to pick a winning stock
Everyone loves a good stock rally and the rise in markets since the middle of this year has been very satisfying. However, as you start to feel more comfortable adding risk to your holdings, you might be concerned that shares are getting ahead of themselves.
In some areas of the market, they are starting to look downright expensive. For example, it is true that the forward price-to-earnings (P/E) ratio on the S&P 500, for example, is near its long-term average. But just because an index looks expensive does not mean that there are no longer deals to be had at the sector or company level.
The quest for income in today’s low interest rate environment means that the more defensive sectors, which typically pay a higher dividend, are now beginning to look pricey. The US market provides a clear example of this. The chart below breaks down the S&P 500 by highest, lowest and average dividend paying companies.
According to the forward price/earnings ratio, the highest dividend payers are now looking expensive relative to their own history and when compared to the low and average dividend payers in the index.
What is interesting is that the average dividend payers are looking cheap relative to the others. These tend to be the type of stocks that can still provide the income investors require. The challenge investors face is not paying too much for the income.
Generally speaking, you’re going to face two key risks when you’re investing in shares for dividend income. Namely, could that income be affected by dividend cuts, or could share prices fall because of changes in the economic background.
How can you guard against these dangers?
Focusing on quality of companies is very important, particularly as valuations rise. You don’t want to be caught out by companies that use higher but unsustainable dividends to attract capital. A high yield has obvious appeal but is no good if the company cuts its dividend next year. You want to look for companies that have visible earnings patterns and sensible valuations.
We tend to think market has been ignoring the average dividend paying stocks. That creates opportunity for investors. Rather than seeking the highest dividend payers in the market, look for companies with strong management teams, durable franchises and consistent earnings that can generate sustainable income. Dividends matter, but so does quality.
Another way to check the sustainability of the dividend is to look at what proportion of the company’s profits is paid to shareholders in dividends. We try to ensure the companies have sufficient additional cash to maintain and grow their businesses as evidenced by modest payout ratios. Modest payout ratios generally mean that these well-managed companies can reward investors with a dividend today while leaving capital available to grow shareholder value and enhance the dividend for tomorrow.
Shareholder value is not served over the longer term if a company is devitalised by high dividend payout ratios. What is the point in a 10% yield if you lose 20% of your capital? In fact, the best performing stocks over the past 20 years have been those with above average yields and below average payouts. The fact that companies which can support recurring dividend payouts are often inherently healthier companies is likely a driver of this strong long-term performance. In addition, the income stream buffers the effect of market downturns, contributing to the lower observed volatility.
When we think about the opportunity set, we look at the financial services sector, for example. The earnings of many finance names are depressed by historically low interest rates. As both loan and securities yields increase there should be a dramatic improvement in the profits of most banks, insurers and asset management companies. One holding that has rewarded us is Wells Fargo. Unusually for a bank it has paid a dividend every year since 1939, and they have increased their dividend five times since the financial crisis.
We also tend to have significant holdings in the consumer discretionary sector, with a focus on US retailers that will benefit from stronger economic growth, such as Home Depot, Williams Sonoma, Dunkin Donuts and others.
It can be easy to overlook, but having the right dividend approach in place for the long-term is important, particularly for investors that rely on an income stream.
Dividends make up a major part of the total return from stocks (since 1926, dividends accounted for more than 40% of the S+P 500 Index’s total return). Plus, stocks that pay dividends have historically outperformed non-dividend-paying stocks.
Fiona Harris is manager of the JPM US Equity Income fund