OCEAN CITY — With interest rates hovering around their historical lows, many investors in recent years have been looking beyond Treasuries and other high-quality bonds to dividend-paying stocks. But not all dividend-paying stocks are created equal. And in today’s markets, you might consider focusing on companies that are increasing their dividends. According to Savita Subramanian, head of U.S. Equity and Quantitative Strategy at BofA Merrill Lynch Global Research, these stocks have proved to be resilient during the volatility of the past several years.
Dividends were once associated with mature companies whose growth years were behind them. Today, however, increasing numbers of growth-oriented companies, including technology and service firms, have started to pay dividends. The current yields from those payments are often lower than the yields investors could get from more established stocks, but Subramanian says that in terms of total return potential, these younger companies might be able to outpace their more mature counterparts over the long term. "We’ve found that companies with lower current yields but growing dividends have historically outperformed higher-yielding stocks," she says. And dividend-growing stocks are currently inexpensive compared with high-yielding dividend stocks.
Subramanian and her team of analysts have identified four criteria that, taken together, may signal that a company’s dividend could be secure and likely to grow.
"You don’t want a company that has seen earnings jump around," Subramanian says. Wide swings may indicate that its profits—and the dividends that are paid out of those earnings — could be threatened during an economic downturn.
Payout ratios are the proportion of the profits that a company is currently distributing to shareholders. The advantage here goes to companies that are giving shareholders a lower percentage. "If a company is already paying out 90% of its earnings, there is no room for its dividend to go up," Subramanian notes. Instead, look for companies with dividends closer to 30% of earnings.
The lower this ratio, the more likely it is that the company will continue paying dividends. When the cost of financing rises, as it did during the credit crisis of 2008, highly leveraged companies could be forced to cut dividends and redirect those earnings to debt payments. In 2008 and 2009, more than 100 companies in the S&P 500 reduced their dividends.
To see how powerful such a record can be, suppose you bought a stock when its dividend yield was 3%. If the company then increased its payout by 15% each year for five years, the dividend yield on your original investment would double to 6%. Today, with average dividend payout ratios well below the historical average, "companies have the potential ability to deliver this type of dividend growth," Subramanian says.
As always, it’s important to work with your Merrill Lynch Financial Advisor to help make sure your investment choices are suitable to your needs and in line with your tolerance for risk, your long-term goals and your liquidity needs. While Subramanian notes that income from dividend-paying stocks may provide some downside protection—which could cushion the blow when stock prices fall—she also notes that they come with risks. "Dividends are not a guarantee that you won’t lose money," she points out. "But compared with focusing solely on capital appreciation, dividend-paying stocks may offer a defensive strategy for investors."
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)