Stocks with fat dividend yields have become a haven for many who are tired of earning a pittance from high-grade bonds, the more traditional security blanket for nervous investors. Morningstar reports, for instance, that the Vanguard Dividend Growth Fund (VDIGX), a popular choice for equity investors seeking income, received nearly $4 billion in net new money last year, representing more than 40% asset growth.
If you like the idea of capturing high dividend payouts but you’re worried that high-yield stocks are becoming a crowded trade, you might consider focusing your search on niches where the lines are shorter. Robert Shearer, manager of the BlackRock (BLK) Equity Dividend Fund (MDDVX), contends that avoiding the most obvious destinations of income-hungry investors can help produce not just healthy dividend payments but stronger overall returns.
“We’ve found that over time it’s not the highest-yielding sector that’s going to give you the best stock performance,” Shearer, whose fund gets a four-star rating from Morningstar, said in an interview. “Often you have to go to the second- or third-best sector to get the highest combination of dividend payments and capital appreciation.”
For him these days, that means bypassing such usual suspects as utilities and telecom and examining, for instance, purveyors of various sorts of consumer goods. He identified three companies that feature above-market dividend yields and, more important in his stock-picking rubric, have grown their dividends consistently for years, if not decades.
Coca-Cola (KO), Johnson & Johnson (JNJ) and V.F. Corp. (VFC) have raised their dividends with assuring regularity, as the chart below shows. In fact, each has increased its payout every year since at least 1991.
Over the last decade, Coke's dividend rose 132%, J&J's 154% and V.F. Corp.'s 248%.
Shearer likes Johnson & Johnson, current dividend yield about 3.4%, especially for its decision “to focus more on its core health brands,” he said. The company has been cutting loose ancillary business lines such as nutrition, he pointed out.
Coke, current dividend yield of about 2.8%, is perhaps less renowned for selling healthy products. Shearer nevertheless expects continued earnings and dividend growth from the beverage maker to be driven in part by a strategy of “making people aware of calories” as the company introduces “new beverages in global markets and lower-calorie substitutes.”
Foreign expansion is also a significant portion of the appeal of V.F., which makes such outdoorsy clothing brands as Timberland and North Face. “V.F. is gaining share in international markets,” he said. “I think there’s a lot of running room for North Face and other brands.” V.F.'s current dividend yield is about 2.3%.
Shearer emphasized the importance, even for income-conscious investors, of judging a company’s ability to generate strong profit growth, not just distribute big dividends. Rising profits tend to go hand in hand with rising dividends, he said, noting that dividend growth is likely to be a stronger component of total return than dividend payments themselves. His rule of thumb is that a company’s stock will produce an annual total return roughly in line with its dividend yield plus its annual rate of dividend growth.
His thinking goes like this: Say a company routinely raises its dividend by 10% a year, so $1, then $1.10, then $1.21. Chances are that its earnings are growing at broadly the same rate. That way, the payout ratio – the proportion of earnings paid as dividends – remains the same. If earnings and dividend growth are 10% a year, then the share price can rise at the same rate without the stock becoming more expensive, plus shareholders pocket dividend after dividend.
“In order to find a good dividend-paying company, you have to go beyond [a focus on yields],” Shearer said. “You want sound balance sheets and free cash flow so that they can fund capital projects and have excess cash to return in the form of dividends. If companies don’t have cash to invest in the business, they won’t have it to grow dividends, either.”
Conrad de Aenlle, a contributing editor at YCharts, has covered investment and personal-finance topics for more than 20 years, writing for The New York Times, International Herald Tribune, Los Angeles Times, Bloomberg News, Institutional Investor, MarketWatch and CBS MoneyWatch. He can be reached at email@example.com.