Global Investment Insight - Dividend Paying Stocks

By M. Isi Eromosele

Stocks have delivered attractive returns for investors over the past few years as we have seen a strong recovery in businesses’ operating results despite numerous global macroeconomic headwinds, proving once again that strong fundamentals often trump near-term headlines.

One particular area that has lagged the recovery in business fundamentals is dividend growth, which is often the case across cycles. However, we believe dividend payoutsare poised for a strong recovery.

The Dividend Cycle

Dividends are an important component of one’s investment results. Historically, it accounts for 43 percent of the equity market’s returns. It is important to note that the contribution from dividends changes over time as the economic cycle unfolds.

Capital appreciation is a large driver of returns in the early expansionary stages of a market cycle, while the contribution from dividends grows as the cycle matures. Our team’s focus on an investment’s total return addresses this by emphasizing capital appreciation, current income and capital preservation through the economic cycle.

The dividend cycle is gaining steam, and there is significant opportunity for dividend growth given corporate balance sheet strength and low dividend payout ratios. Corporations are in great shape financially with approximately 11.3 percent of their balance sheets in cash, versus a historical average of 8.6 percent.

Pre-tax profit margins of 12.3 percent are also near a 40-year high, and free-cash-flow yields remain attractive at 5.47 percent, currently, relative to the long-term average of 3.69 percent. In contrast, the payout ratio on the S&P 500 Index is at an all-time low of

28 percent.

This disconnect between strong corporate financials and low payout ratios indicates that companies can grow their dividends significantly in the coming years. This is beginning to take place as evidenced by the rise in the number of companies increasing and/or initiating dividends.

The emergence of the dividend cycle can have an important effect on investors’ portfolios, especially given the dynamics of today’s low bond yields. The challenges of a yield-starved world have led many income-seeking investors to accept greater risk within the bond market, as reflected in the low yield spreads between corporate bonds and Treasuries. This exposes investors to interest rate risk once inflation and interest rates eventually rise.

Additionally, investors are underappreciating the risks posed by the “yield trap,” which occurs when investors compromise total return for the sake of current income. High dividend yields alone do not make an investment attractive.

Differentiating between a “yield trap” and a sound investment is where active management becomes an imperative and there is simply no substitute for fundamental research when assessing the total return potential for an investment.

Emphasis should be placed on the growth and sustainability of a company’s dividend, not the absolute level of its yield, along with the opportunity for capital appreciation and potential downside risk.

The Evolving Market Cycle

Market leadership is changing. The cyclically biased leadership of the last two years has run its course and our positioning is currently more biased toward stable-growth companies, rather than companies leveraged to the earlier part of the market recovery.

Our fundamental research has identified many attractive investments in cyclical industries that we believe are underearning versus our estimate of their normalized earnings power, which is the level of earnings that our team estimates for a company based on an average or normal market environment.

We have also seen a significant increase in the relative valuations of cyclical companies versus stable growers. Cyclical companies’ free cash flow yields have gone from 1.5 percent higher than that of more defensive names at the beginning of the cycle, to a near-low 2.1 percent below the free cash flow yield of defensive stocks.

Investors should remain consistent with their sell discipline and reduce their exposure to cyclical companies as the risk/reward opportunity became less favorable, and expectations surrounding the duration of emerging market growth remain high.

Today, we are much less cyclically biased and believe valuations are more attractive in stable growth areas, such as consumer staples, where the near-term concerns of rising input costs have pressured valuations. Our analysis of these businesses over prior market cycles indicates they have the ability to pass along cost increases, which we believe is underappreciated by many investors.

Ongoing Recovery In The Credit Cycle

The credit recovery is long underway with both delinquencies and charge-offs well off their peaks and showing continued improvement during the past year. However, bank loan growth has remained elusive with little improvement despite reaching peak level of declines, contracting over 9% (annualized).

 Still, though lending has been relatively anemic, there are reasons to be encouraged. Businesses have ample ability to borrow as their leverage (debt/equity) is at a 20-year low, free-cash-flow yields are well above historical norms (5.55 percent versus 3.78 percent) and corporate liquidity (liquid assets/net worth) is at a 60-year high of 13 percent.

Consumers have also made significant strides: Financial obligations and debt service ratios are at the lowest levels since 1995. Today, overall loan growth has been flat for the last two quarters, with business loan growth (commercial and industrial) of 6.9 percent being offset by continued declines in consumer and real estate loan balances.

However, loan demand is now positive and lending standards or banks’ willingness to lend are easing for both businesses and consumers, signaling a likely return to loan growth in coming quarters.

Improving outlook For The M&A and LBO Cycle

The fundamental ingredients are in place for a potential upturn in mergers and acquisitions and leveraged buyouts, which could be supportive of equity valuations going forward.

Corporate balance sheets are strong with high cash balances and leverage at 20-year lows. Coupled with the ability to borrow very cheaply and pay attractive prices for equities, the landscape for M&A has clearly improved and is quite favorable.

Corporate debt is inexpensive given historically low interest rates and investment-grade yield spreads have narrowed significantly versus 10-year Treasuries and are back near pre-recessionary levels.

Recently, we’ve seen a small increase in M&A activity and for the most part, the acquirers have not been punished too badly by investors. It is too early to establish a trend, but we believe the fundamentals are in place for M&A to increase going forward.

While the investment opportunity set has narrowed during the last two years, investors who remain focused on long-term business fundamentals can do well, particularly with dividend-paying stocks.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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