The dividend spree is just beginning

The good times are set to last, and investors are now focusing on the next wave of big payouts.

By StreetAuthority May 6, 2013 3:07PM
Woman reading newspaper in livingroom copyright Tetra images, Getty ImagesBy David Sterman

At first blush, it's hard to reconcile a pair of percentages: 2% and 22%.

The first figure is roughly the speed at which the U.S. economy has been growing. The second figure is the speed at which dividend payments grew in 2012.

In fact, all of the companies in the S&P 500 distributed a collective $310 billion in dividends last year, according to FactSet Research, well higher than $255 billion doled out in 2011 and the previous record of $265 billion in 2007.

Logic would tell you that a slow-growing economy and record dividend payments means this trend must cool off. Yet a pair of factors suggest that dividend payments can grow at a solid 10% pace for a number of years to come -- and for certain companies, a much faster pace than that.

Do the numbers
The fact that the economy remains in a subdued state -- and we're unlikely to see GDP growth of more than 3% anytime soon -- doesn't mean that corporate profit growth is in trouble.
 
Companies continue to find ways to streamline costs. As a result, they're able to generate net income growth in the 5% to 10% range. Many companies are now aggressively buying back stock, allowing per-share profits to grow at a slightly faster pace.

Analysts currently expect aggregated profits in the S&P 500 to rise around 8%. Simply keeping payout ratios constant would provide for 8% dividend growth. But payout ratios aren't constant -- they're rising.

The reasons behind rising payout ratios are twofold.

First, companies amassed massive cash hoards after the 2008 economic crisis. Many are now realizing that they have gone too far. Companies like Apple (AAPL) are sitting on absurd amounts of cash -- and starting to plan for a future with less cash. Much of that cash will go toward dividends.

Second, the low-growth economy means that companies see little reason to make major investments in growth initiatives, and realize that it no longer makes sense to earmark a high level of annual profits into capital spending. So they are boosting the payout ratio instead.

In the fourth quarter of 2012, companies paid out 30% of their profits in dividends. That's up from around 28% in 2011 and in line with the 13-year average (when recessionary years are excluded).

Yet a look back much further, to the 1960s and 1970s, finds that payout ratios often exceeded 40%. The parallels between then and now are quite similar. As is the case now, slow economic growth meant fewer needs for retained cash in which to invest in the business. And in each period, investors are clamoring for dividend growers, bidding up shares of any company that has boldly hiked its payouts.

Let's take a look at the S&P 500's most aggressive dividend boosters of 2012 and see how the market responded to their shareholder-friendly moves.



Seven out of these 10 stocks have outperformed the S&P 500 since the start of 2012, racking up an average gain of 50%. Even if you exclude Seagate Technology and its hefty 163% surge, this portfolio would have racked up a 37% gain. The fact that this portfolio offers an average dividend 1 percentage point higher than the S&P 500's average 2.1% dividend yield makes the total return even more impressive.

The key to finding companies that have a shot at sharply boosting dividends is to focus on companies that still have a low payout ratio. For example, retailer L Brands (LTD) (formerly known as The Limited) has been a great dividend growth story, boosting its payout an annual average 21% over the past 10 years.

But L Brands' payout ratio now approaches 40%, and management is unlikely to go much further than that. So this retailer's dividend growth probably will only grow at the rate that profits are growing. In its current fiscal year, analysts expect L Brands' per share profits to grow just 8% (to around $3.14), so double-digit dividend hikes may be a thing of the past.

Yet many companies have payout ratios that are well below the S&P 500 average of 30%. In part two of this look at aggressive dividend hikers, I'll be focusing on companies with dividend yields of at least 2%, payout ratios below 25%, and analysts' expectations of rising profits. You'll find some attractive names in this group.

Risks to Consider: Dividends were cut sharply in 2008, and the same thing can happen again of the economy cools in the next year or two. At the moment, the economy appears to be on sound enough footing to avoid any near-term downturns.

Action to Take: The trend of fast-rising dividends is far from played out. Cash-rich companies, many of which are also generating robust cash flow, are increasingly hopping aboard this trend. As long as payout ratios remain below 40%, there is more room for dividends to grow even faster than profits.

The fact that many economists expect profit growth to accelerate in a few years as Europe and other struggling economies get off the mat tells you that dividends may eventually grow strongly even without a hike in the payout ratios.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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