Chasing yield has become a challenging mission for investors
in recent years. As yields collapsed in fixed income, investors
flocked to bondlike substitutes, such as high-dividend-yielding
stocks. Now that these stocks have become a bit pricey, we
think companies with strong dividend growth potential offer a
better way to source equity income.
There are many ways to look at dividends. A good starting
point is the payout ratio, which measures the proportion of net
income that a company pays out to shareholders. At the end of
2013, U.S. companies were paying out only one third of their
earnings as dividends, well below the average of the past 60
years (see chart 1).
Payout ratios matter. When they are low, the ratios show
that many companies have lots of room to raise dividends. And
since U.S. companies have record cash positions and solid
balance sheets, we think its easy to envision how payouts
This ratio also helps explain why dividends have been
growing faster than profits. For U.S. nonfinancial companies,
earnings growth remained sluggish in 2013. Yet because payout
ratios were so low, dividend growth outpaced earnings growth by
a wide margin (see chart 2). And since companies with strong
dividend growth typically have not been on investors
radar screens, theyre trading at especially cheap
valuations when compared with high-dividend-yield stocks.
There are examples of this in many sectors. In aviation,
Chicago-headquartered Boeing Co. increased its annualized
dividend by 50 percent at its board meeting in December.
Minnetonka, Minnesotabased health insurance company
UnitedHealth Group raised its dividend by 32 percent in 2013.
Woonsocket, Rhode Islandheadquartered consumer staples
retailer CVS Caremark lifted its dividend by 30 percent last
year. And even in financials, San Franciscoheadquartered
financial services company Wells Fargo & Co. boosted its
dividend by 31 percent. What do all of these companies have in
common? Low-dividend-payout ratios.
So how can we identify companies with strong dividend growth
potential? It all starts with the payout ratio. When a company
has a high payout ratio, it often means management does not see
compelling opportunities to invest in growing the business. We
believe that companies with lower payout ratios have more
control over their destiny than do peers with weaker cash
dynamics, which gives them capital flexibility to invest in
projects for future growth or to return excess capital to
shareholders by increasing dividends or share buybacks.