Picking High Dividend Stocks For Your Family’s Portfolio

I was thinking about how the last ten years in the American equity markets have been somewhat difficult for income investors that seek high current dividend yields as bank deposits and Certificates of Deposits saw their interest payment rates plummet, the stock market boomed making it difficult to find reliable high yielders, and various income-producing fads and overvaluations have arisen in the interim to lure those who seek dividends to support their lifestyle or build a cash-generating infrastructure so that they always have cash coming in the door to make fresh investment.

Let’s discuss the historical and present environment for income investing.

I. The High Dividend Investment Fads Of The Past Decade

Three fads came and went in response to the difficulty of finding attractive investments in the low-interest rate environment over the past ten years.

First, income investors put money into closed-end funds that paid out 15-25% annual returns and, disregarding the farmer’s adage that “pigs get fate and hogs got slaughtered”, invested in these concoctions that were leveraged by a factor of 5:1. This is an important data point to keep in mind: There is no such thing as a closed-end fund that yielded over 10% for ten years in a year without cutting its distribution to its owners. It doesn’t exist, and that should tell you all you need to know about the stability of this investment category.

Then, investors overbid the price of real estate investment trusts, which led to the creation of price points that would depress future returns. Realty Income, the best real estate investment trust in existence, hit a price of $71 per share in 2016. That was completely bunk, from a rational perspective valuation. The stock may not fairly be worth $71 per share until 2021. This was harmful because most real estate investments only grow at a clip of around 6-8%. In search of high income, investors bid these stocks up to prices where the starting yield fell to 3-4%, meaning that a 2016 investor in Realty Income might only find himself with 5-6% annual returns during the 2016-2026 time frame. When you are dealing with slow growth, you absolutely cannot overpay. I categorize this moment as a fad because investors flocked to real estate not because they understood it well and wanted to own it, but rather, because they couldn’t find anything among S&P 500 companies that met their needs.

And third, by far worst of all, was the MLP energy investing craze of a few years back. Master limited partnerships like Buckeye Partners are sound investments, but a majority of the sector is extremely overleveraged. That meant that when the oil prices fell, starting in 2014, a wave of bankruptcies and equity dilutions followed as the amount of income generated by the MLPs fell and debt obligations could not be honored.

And the dangest thing? The management teams of the various MLPs did not change their strategy post-bankruptcy. Take a look at the debt on the balance sheets of MLPs even today. It’s just debt, debt, debt, everywhere. Financial analysts who cover the MLP space cannot claim that this sector cleaned up its act as the same debt burdens exist today as those that existed in 2014. If there is another deep decline in the price of oil, the price will fall once again.

II. The Really Simple Solution

If you want sustainable income, the process for selecting a good candidate for investment is surprisingly simple.

Limit yourself to investments that share the following characteristics:

  1. No dividend cuts in the past ten years.
  2. No extreme debt burdens.
  3. Profits that are higher than the dividend payments, even when stress-tested for a recession.
  4. Business models that cannot become obsolete in the face of technological change.

If you limit yourself to investments that meet the above four criteria, you won’t fall victim to fads and you’ll build a collection of assets that you reward you for your labor.

I contemplated including a fifth rule, never invest when the dividend yield to ten year bond spread is greater than four percentage points—i.e. if a ten-year treasury pays out 3%, don’t consider stocks that yield above 7%. But I ultimately dismissed the rule as the best time to buy oil stocks during the past decline included periods when Royal Dutch Shell and BP yielded over 7%.

I understand why investors are drawn to high income-producing securities. A single well chosen investment, held for long periods of time, can singlehandedly fund a nice lifestyle or perpetually give you new investments. Someone who bought and held shares of ExxonMobil over the decades would be receiving dividend income that could buy a new car, pay off the house, or send kids to school. Or, it can fund your own entrepreneurial efforts. But you must not “overreach.” The pursuit of too much income can destroy your efforts to reach your cash flow goals, and therefore, great care must be exercised to avoid the seduction of those investments with present dividend yields in the high single digit or double-digit range.

III. AT&T: Case Study Of A High Yielder

Generally, a business like AT&T is a classic example of what it means to invest in a high yield stock with sustainable dividend payments. The telecommunications company is so vast and profitable that, during the Great Depression, it was referred to as a “widows and orphans” stock because every trust officer at the local bank was expected to hold it as a foundational stock for those who needed income but were unable to participate in the labor markets.

Critically, during each of the past 50 years, AT&T’s dividend payout has been than the amount of profit that it brings in. This self-evident truth is the foundation of sustainability in income investing, but is sometimes ignored by others who reach for higher dividend yields.

Right now, AT&T pays out a dividend of $2 per share annually. Over the past twelve months, it has earned $3.10 per share. At the corporate level, what is happening is that AT&T is bringing in $18.5 billion in profits and is paying out a little over $12 billion to shareholders as dividends.

The “reliability” of the dividend is that its customers will not abandon its phone and internet and TV services, and even if there were a downtick in pricing, AT&T still has a $6 billion profit cushion that can keep the dividend payments coming in.

And management has been intelligent about making the dividend increases sustainable. The dividend has only gone up a penny per share quarterly during each year since 2008, but the caution in raising the payout is the reason why the company is in a position to withstand adverse circumstances and keep the dividend rolling.

Every fifteen years or so, AT&T shareholders receive the amount of their initial investment back in the form of cash dividends. If they are in position to reinvest, they receive payouts totaling their initial principal within a decade of their initial investment.

A large position in a stock like AT&T creates significant opportunities to fund your lifestyle and further investment. An investment over the years, totaling 5,000 shares or so of AT&T, means you get $2,500 dividend checks every quarter.

IV. What Other Income-Producing Investments Produce Similar High Income?

High-yield dividend stocks generally congregate in the following segments: (1) telecommunications companies like AT&T and Verizon; (2) fully integrated oil companies like Exxon, Chevron, BP, and Royal Dutch Shell; (3) tobacco giants like British Tobacco, Altria, and Philip Morris; (4) certain out-of-fashion pharmaceutical stocks like GlaxoSmithKline, and (5)  real estate investment trusts like Realty Income and W.P. Carey.

In the case of the telecommunications companies, the high yields are the result of limited possibilities for earnings per share growth because the two major market participants conduct hundreds of billions of dollars in annual revenues.

For the integrated oil majors, the possibility of investing in new oil finds and extraction methods are limited, making a cash return to shareholders the best use of capital. In years like 2008, Exxon cannot reinvest $35 billion in profits back into the company, and so it is necessary to send a chunk to shareholders and save the rest for a rainy day when the price of oil is low. This is also an investment cultural expectation in that Exxon and Chevron trace their lineage back to Standard Oil, which has an uninterrupted streak of continuous dividend payouts dating back to 1882.

In the case of big tobacco, the reason for the dividend yields is that the underlying industry is in decline (since 1982, the volume of cigarettes smoked in the United States has declined by an average rate of 3.5% each year) and fear of future regulation and taxation has traditionally limited the valuation, giving the sector high starting yields at the time of the initial investment.

With Big Pharma, you should pay close attention when a key drug is going off-patent or losing its exclusivity of distribution status, as the magnitude of the price decline frequently exceeds the actual hit to the firm’s intrinsic value. The downside is that it is not uncommon for the shares to tread water for a few years before a new promising drug leads to a rapid change in the stock’s price as the better fortunes manifest themselves. Before making such an investment, you should make sure that the expected profit loss from the major drug does not send the profit figures to a level that is lower than the amount of the dividend.

And lastly, real estate investment trusts can be dependable source of income but require heightened vigilance because it is easy to take catastrophic risks in reaching for future growth. REITs grow profits by collecting more rents, and usually, the rents of a REIT rise by purchasing additional properties (rather than just raising the rents of the existing premises). When a REIT adds to its properties, it often funds the acquisition with debt. If the vacancy rate is a bit higher than expected, the results can be devastating quickly.  A bad CEO can wipe out a REIT with just a single bad borrowing transaction. That type of risk does not manifest itself as much in the other yield categories.

V. So Why Don’t All Income Investors Buy These Type Of Dividend Payers?

Some income investors are lured by the prospect of a higher dividend payout—they want to get $100 in dividend income for every $1,000 that they invest. As the great Benjamin Graham once said, “More money has been lost reaching for extra yield than has been lost at the barrel of a gun.”

Instead, they find themselves flocking to businesses like CenturyLink, which has a present dividend yield of 12%. People see that high starting yield, and they talk themselves into a tizzy trying to justify it. “Maybe the dividend could be cut in half, and I’d still get a 6% dividend…” or “I’ll see in the event of a dividend cut…” the inner monologue goes, trying to come up with a justification for the business so they can get their hands on the dividend.

That is the wrong way to approach income investing. You pick the universe of desirable businesses first, and from there, you narrow your selection process to those that have an attractive dividend program. You don’t find the universe of high yielders, and then declare allegiance to the most justifiable of the junk that shows up.

Anyone who takes a look at Century link will see that it is paying out around $2 billion in dividends while earning $1 billion in profits while carrying a debt burden of $37 billion. Those numbers are compatible with the prospect of collecting high dividend checks fifteen years from now. It is entirely possible that the magnitude of the capital loss from such an investment will exceed the gross amount of dividends collected over that time frame. A deep recession would lead to a bankruptcy absent accommodating restructurings with creditors.

The Conservative Income Investor Rules For High-Yield Dividend Stock Selections:

  • Limit the scope of your inquiry to only businesses that are earning profits in excess of the dividend payout, especially when dealing with non-cyclicals during a non-recessionary environment.
  • Exclude companies with unsustainable debt burdens. Very few large-cap businesses exist in the world with a debt-to-profit ratio in excess of 8:1. When you see stocks carry debt burdens that are grossly in excess of this, you should avoid investment due to the heightened risk of bankruptcy.

We are still at the point in which the 2008-2009 recession is included in the ten-year dividend and earnings data for any contemplated. If you invest in a stock that had to cut its dividend in the past decade, you cannot act surprised if you find your dividend payment cut during the next recession.

Investment screening is going to become substantially more difficult in 2020, if there is recession before then, in that dividend growth streaks and continuity of distributions for various investments will not include a measuring period of truly challenging economic conditions.

VI. The Best High-Yielder Right Now

Right now, I believe the best high-yield common stock investment is the ADRs for GlaxoSmithKline (GSK). It is estimated that Glaxo will pay out around $2.50 per share in dividends this year (management makes dividend payments as a percentage of earnings, so the exact amount is imprecise to predict). At the current price of $39 per share, we are talking about a starting dividend of 6.4%. It has a seventy-year track record going back to its roots as SmithKline of making dividend payouts, and just bought out Novartis’ share of the joint venture stake for a $14 billion consumer division that included Voltaren Gels for muscle pain, Panadol headache pills, and Sensodyne toothpaste and mouthwash. It has some small-pharma drugs growing at 40% annualized.

It’s been a long slog, but it slowly re-establishing itself as a business that is within hailing distance of Johnson & Johnson in terms of quality. People who have sat there and done nothing but reinvest for the past twenty-five years have found their dividend yield approaching 85%–i.e. a $10,000 investment now pays out $8,500 each year.

The total returns haven’t been as impressive, as the stock has hardly budged. That can change in a hurry though. If GlaxoSmithKline turns out a few nice quarters, and the price of the stock rises to $63, which would not be anything out of the ordinary on a P/E basis, the stock would suddenly have a twenty-five year record of outperforming the S&P 500. In that event, all those dividends reinvested in the $40s would look brilliant as you were issued “free” shares at $39 that are suddenly worth $63, in addition to the increase in the value of your principal as well.

There aren’t many safe and sturdy ways to find a 6.4% dividend yield. Glaxo is one of the few that can blend investment quality with high current income. My expectation is that long-term returns will be in the range of 7-11% annually over the long haul (the wide band is the result of difficulty predicting the future size of various pharma drugs in the company’s portfolio). At a minimum, you should get high current income and general stock market performance, but there is a fair chance you may get high current income and stock market outperformance, and that is why I pay attention to Glaxo.

VII. Conclusion

My personal investing preference for high yield investing is this:

  1. See if there are any high-income generating pharmaceutical stocks, ideally with a consumer healthcare division, that are trading at a discount.
  2. See if there are any tobacco stocks trading at a valuation below 14x earnings, as this is the valuation metric in which you get both high income and future outperformance, and are well compensated for regulatory and taxation risk of the sector.
  3. See if Royal Dutch Shell and BP are yielding over 6.5%, or Exxon Mobil and Chevron are yielding over 4%. These are price points where future success is a likelihood. Exxon is likely one of the best income investments you can make today, and I would choose it ahead of even GlaxoSmithKline if capital appreciation is as important to you as current income.
  4. See if REITs are yielding over 6% with a manageable debt, and restrict yourself to the excellent management teams of firms like Realty Income and W.P. Carey.
  5. If all else fails, buy more AT&T.