Almost Too Obvious: For Holy Grail of Dividends, Why Coca-Cola and McDonald’s Demand Attention
If there were a trade association of dividend-paying corporations they would surely be handing out a lifetime achievement award to Federal Reserve chairman right about now. Bernanke’s beat-down on interest rates has pushed the yield on Treasury and high-grade corporate debt so low that income investors have little choice but to venture into the land of dividend paying stocks and their bond-beating yields.
But shopping for income based on a stock’s current yield is like settling for a single when you could easily coast into third with a stand-up triple. The real payoff comes when you shift your dividend focus to the growth pattern of the dividend over time. Think about it: when you buy a bond your income payout is fixed—that’s why they call it fixed income after all. But the income payout on a stock is not fixed. It can rise, fall or stay right where it is. Find a company with a long history of increasing its dividend and a balance sheet that suggests it can keep up that habit, and you’ve hit on the true dividend holy grail.
A new paper from Fidelity, Looking Backward and Forward at Dividend Growth did some interesting slicing and dicing of data. The money managers found that over the past 20 years focusing on the highest dividend stocks in the S&P 500 added 1.7 percentage points of return relative to the overall index. Only problem was that shopping only on the basis of yield pushes you to overweight a single sector, namely financials.
During the 20 year stretch Fidelity found that if you focused on the top quintile of S&P 500 yielders you would have had a 22% weight to financials vs. 16% for the overall index. And as many found out from painful experience, heading into the third quarter of 2008, if you were focused on the highest yielding quintile of the S&P 500 you’d have had a 37% exposure to financials vs. 14% for the overall index.
THE BETTER DIVIDEND PLAY
Fidelity found that shopping among the dividend growers-irrespective of their current yield-was the far better way to go. When it went back over the 20 years and identified firms with positive dividend growth it found that the average annualized return for the dividend growers over the next 12 months beat the return of the S&P 500 by nearly 5.5 percentage points.
Sure, Fidelity’s model had it easy—it was using historical data to see who actually had the positive dividend growth and then looking at what happened to those stocks over the next 12 months. Real world investing isn’t that easy. Dividends and dividend growth aren’t promises. They can be cut, or growth can be halted. But find yourself a company with a long history of delivering on the dividend front and you’ve got yourself at least to second base.
Ten years ago Coca-Cola’s (KO) 40-cent dividend wouldn’t have wowed a yield seeker. If you bought a share of Coke at its 2002 high, that 40-cent payout would have generated a dividend yield of 1.3%. This at a time when the 10-year Treasury was yielding around 4%. But Coca-Cola consistently increased its dividend payout. Anyone who bought 10 years ago has seen the dividend payout more than double.
For someone who bought at the 2002 high and still owns that share of Coca-Cola, today’s $1 per share annual dividend works out to a yield of nearly 3.5%.
McDonald’s (MCD) has an even juicier dividend growth story as its per-share annual dividend has grown from 24 cents 10 years ago to $2.71 today. That 24-cent payout meant a measly dividend yield below 1% for someone who bought at the 2002 high. But that same share would now deliver a yield of nearly 9%.
Stable, consistent dividend growth also has a funny habit of portending strong performance in the underlying stock too.
Here’s just the price performance of Coca-Cola and McDonald’s relative to the broad market.
Okay, so Coke’s price performance isn’t much better than the overall market.
Now let’s add in the dividend piece and take a look at the total return:
Sure, it’s nice to get in on a McDonald’s story, but even a plodder like Coca-Cola can best the market based on its stellar dividend growth.
This is a point Berkshire Hathaway (BRK.B) Chairman Warren Buffett has crowed about. In the 2011 annual report he said that when he finished building Berkshire’s Coca-Cola stake in 1995 it delivered Berkshire shareholders an $88 million dividend payout. The dividend payout is now north of $375 million. Buffett said he expected the dividend payout to double again in 10 years, adding “By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the business.” You can’t get that out of a bond.
Now one big problem with all this is that there’s no way to know for sure who will be able to keep up the dividend growth going forward. Sure, Coca-Cola and McDonalds have a great track record, but if you’re buying now you want at least a heavy hint it can keep up the dividend growth.
Focus on cash flow. As the Fidelity folks pointed out: “Understanding future cash flows is a critical precursor to predicting dividend growth, and to the extent that an investor may be able to anticipate future dividend growth, portfolio performance may be enhanced.”
Hmmm. Apple’s (AAPL) 1.8% dividend yield is far from impressive. And to be sure, given that the Cupertino brain trust just started paying out the dividend this year, there’s no way to divine their commitment to dividend growth. But man, take a look at free cash flow.
That says a lot about why Apple finally relented and started to dole out dividends. At an annual rate of $10.60 per share, the current dividend is about one-quarter annual per-share earnings. That suggests Apple, if it wants to, is certainly set up to be an impressive dividend grower going forward.
Carla Fried is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.