Motley Fool Hidden Gems Investing - Dividends 101

Episode Date: July 9, 2022

Warren Buffett isn’t planning on paying his shareholders a dividend, but he’s a big fan of getting a piece of his stocks’ profits. Ricky Mulvey joins The Motley Fool’s Matt Argersinger and Anthony Schiavone to talk about the fundamentals of dividend investing, including: - The case for buying dividend stocks - How to spot healthy payouts - A few interesting income-generating opportunities Tickers mentioned: BRK.A, BRK.B, GE, KO, MTN, VYM, VIG, NOBL, EBAY, DGX, EPR Bonus Resource - List of Dividend Aristocrats - https://www.fool.com/investing/stock-market/types-of-stocks/dividend-stocks/dividend-aristocrats/ Host: Ricky Mulvey Guests: Matt Argersinger, Anthony Schiavone Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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BetMGM operates pursuant to an operating agreement with iGaming Ontario. What you have to remember that the vast majority of companies, and when I say vast majority, I'm thinking 99% of companies, aren't able to really reinvest for high rates of return for long periods of time. It just doesn't happen. You might have companies that can do it for 10 years, 15 years, maybe even 20 years, but eventually most companies aren't really reinvesting at high rates of return. They just can't do it. I'm Chris Hill and that's Motley Fool senior analyst, Matt Argersinger. Warren Buffett is very much on track to never pay a dividend at Berkshire Hathaway, but he sure does like

getting them. Berkshire Hathaway is expected to receive about $5 billion in dividend income this year. When you're an investor, you're the part owner of a business, and this episode is all about getting a piece of the profits your businesses are generating. Ricky Mulvey talks with Matt Argersinger and Anthony Chavone about how to find some interesting income opportunities. Welcome to Dividend Investing 101. We're looking at capital allocation with The Motley Fool's own dividend kings, Matt Argersinger and Anthony Chavone from our mogul and real estate winners, Investing Services. Good to see you both. Hey, good to see you, Ricky.

How's it going? Going well. Let's start with the fundamentals. We'll talk a little bit about historical performance with dividend companies, potential risks, and then maybe get you some ideas if you're an investor thinking about entering dividend land. 101, we'll start with the basic question. Why would a company choose to pay a dividend? They have a few different options with share buybacks, maybe acquisitions, depending on how you're looking at the cash flow statement, or just holding on to all of that cash. Why do you you like dividends? One of the reasons why Ant and I like dividends, besides the obvious, which is you get on a monthly or quarterly basis, you get a cash payment from the company.

Depending on the company, it can be a nice yield. If you're an investor who's looking for income, that can be a great thing. But I think dividends have gotten a little bit of a bad rap. This might seem strange, but I'm actually going to blame Warren Buffett for this. Because as we know, Warren Buffett, the CEO and probably greatest investor on the planet of Berkshire Hathaway, Berkshire Hathaway has never paid a dividend, at least since he's been the CEO of the company. He's always said, why would I pay a dividend if I can reinvest the capital I get at higher rates of return?

If Buffett can invest and earn a 9% return on capital, why is he going to pay that out as a dividend where it probably comes out as a 3% or 4% yield? But what I think that has done is, it's convinced a lot of investors and a lot of CEOs, actually, that paying dividends is a bad choice. But what you have to remember is that the vast majority of companies, and when I say vast majority, I'm thinking 99% of companies, aren't able to really reinvest for high rates of return for long periods of time. It just doesn't happen.

You might have companies that can do it for 10 years, 15 years, maybe even 20 years, but eventually, most companies aren't really reinvesting at high rates of return. They just can't do it. So, buybacks are a nice solution sometimes, but that can sometimes compound the problems. We know throughout history, companies really aren't great at share buybacks. And so, if you have excess capital, what are some of the best ways to help your shareholders? I think paying a dividend should be top of mind. It's a great way to put the decision in the hands of your investors and say,

hey, we have this excess capital. It's your capital. We can't find really good uses of that capital right now. we're going to pay it out to you as a dividend. And you, the investor, can make the best decision for yourself as to how you want to reinvest that dividend. So, I think it's part history. It's part because we've had this crazy bull market where companies that rose the most in value didn't pay dividends generally. They were tech companies, small growth companies, biotech companies. But I think, and again, I think dividends have gotten a little bit of a bad rap from people like Warren Buffett and others who have kind of derided the idea of paying them. But I think

Dividends are a great use of capital sometimes. I hope board companies pay them. Going back on something you said, yeah, dividends have been around for way longer than 100 years. This hip new investing trend was started by the Dutch East India Company. A little fun fact for the history nerds out there. Anthony, give me your pitch. What's the pitch? If you're an investor, maybe newish to the stock market, why should you care about the dividend? I think companies that consistently pay a dividend and actually increase that dividend on an annual basis, I think they usually have some sort of economic moat that enables them to generate that cash flow to consistently pay out dividends. And just an example that comes

to mind is Coca-Cola with their strong brand image. They use that to generate consistent cash flow and earnings, which eventually leads to consistent dividend growth. That's one thing you can look at for dividend yield is some sort of economic moat or some type of competitive advantage. Another thing that I think is important when looking at a company's dividend or changing its dividend policy is you get a pretty good indication of the financial health of the company because you simply can't fake the cash that is being paid out to shareholders. So that dividend payout is pretty much correlated with earnings growth. But it also gives a glimpse of management's expectations for the future. A company that comes to mind is Vail Resorts.

They had to cut their dividend during COVID because obviously their business was hurt pretty bad with closures and the lack of international travel. But they reinstated it, although at a lower yield last September. So, you could see the business was improving. That was a sign that it was a step in the right direction. And then in March, they increased that dividend above its pre-pandemic level. So, that's a pretty good sign that the company's doing well, and management has pretty big expectations for the future. I'll just add one more reason here why a company may pay dividends. Sometimes they're actually required to do so. REITs, or real estate investment trusts, they're actually required to pay out at least 90% of their taxable income in order to receive

that special tax treatment they get on corporate profits. So, for that reason, REITs usually carry a higher dividend and don't necessarily have as much retained earnings to initiate a buyback program. Anthony, you touched on dividend cuts a little bit with Vail Mountain Resorts. I think it is worth describing why management teams are so reluctant, hesitant to cut dividends, even when their business is in a little bit of trouble? Yeah. I mean, I think in the case of Vail Resorts, it wasn't so much management's fault that they were cutting their dividend. It was obviously a once-in-a-lifetime pandemic came along. So it was kind of understood by their investor base why they were cutting that dividend.

But yeah, I think if there's some reason that the business is underperforming and there wasn't a pandemic that resulted in the dividend cut, I think that would have had more of an effect from the shareholder's view. Yeah, I think with looking at the pandemic, especially a company like Vale or other hospitality companies, travel companies, retailers, cutting the dividend was an obvious choice to preserve capital, protect the balance sheet, and live to see another day, or at least live through the uncertainty of the pandemic. It wasn't a surprise to see a lot of companies cut their dividend. That happens from time to time. and it's usually one of the first things to go once a company runs into financial trouble.

But of course, the key, if you're a dividend investor, is to find companies where you can be confident the dividend is sustainable, that it can grow, and it can continue to be paid out and grown through multiple business cycles. We're in a bear market right now. Nobody welcomes it, but it happens as a stock investor. How have dividend stocks historically performed in bear markets? Standard & Poor's actually did a study earlier this year that found that dividend aristocrats, which are companies that have increased their dividend payout for at least 25 consecutive years and are a part of the S&P 500, they found that they outperformed the S&P about 69% of the time since 1990 in months where the S&P had a negative total return for a single

month. That's pretty impressive. They also found that the risk-crash generated an excess return of about 1% over the return of non-dividend growing companies in a down month. I think a lot of that outperformance can probably be attributed to the economic moat that a lot of these dividend growers have, which also leads to consistent earnings growth as well. There's also some data you got on how dividend companies perform during periods of high inflation. There's actually a study from Cohen and Steers. It was a 2011 report, so a little bit dated, but we really haven't had inflation over that time until now. But they found out that since 1972, in periods where inflation was between 4% and 6%, companies who routinely pay a dividend

outperformed non-dividend payers on a total return basis by about 15% annually. That's a pretty big difference there. The difference is even greater when you look at companies who routinely increase their dividend. That outperformance jumps to about 17.5% over non-dividend payers. I think a big part of that, again, is the economic moat and also the pricing power that a lot of these dividend growers have. Let's get into the nuts and bolts if you're looking at a company that pays a dividend, what are some of the specific metrics that you guys are watching? I think first and foremost, if you're a dividend investor and your concern is, can this company continue to pay that dividend?

Can that dividend be grown over time? I think you want to start with looking at the payout ratio, which is a very common ratio if you're a dividend investor. Essentially, what you're looking at is taking the current dividend payout, say it's $0.50, and then looking at the company's trailing 12-month earnings, say that's $1. If the company earned $1 and it's paying out a $0.50 dividend, to use a very simple example, that means that payout ratio for that company is 50%. Anthony and I would view a payout ratio of 50% as pretty sustainable. Generally, if you're looking at dividends, a dividend company, I'd say anything 60% or lower in terms of payout ratio feels like a fairly sustainable dividend.

Now, some companies you can let have a higher dividend payout ratio. For example, if it's a utility company, or we can talk about real estate as well, even though you calculate the payout ratio for real estate companies a little bit differently. But with those kinds of businesses, real estate and utilities, where there's very clear earnings visibility, you have a lot of confidence in what the company's going to earn over the next year or two, you can let that payout ratio go higher, sometimes 70%, 80%. But anything above that, I think you should start getting a little concerned about whether or not that dividend payout is sustainable. And then after that, looking at the payout

ratio, look at earnings and earnings per share. Have earnings per share grown at a consistent rate? And has the dividend payout ratio moved in tandem with that? As long as the company is growing its earnings over time, it's a good bet that that dividend is going to continue being paid and that the dividend is probably going to be increased over time. Hartford Funds did a survey or a study earlier this year that showed that over the past 95 years, the average dividend payout ratio in the S&P 500 was about 57%, which is not too bad. But as of the start of this year, the payout ratio was just about 31%, so a lot lower than the historical level. I think when you factor in strong earnings growth, which we've seen for much of the last

decade, the strength of corporate balance sheets, and then that low payout ratio, I think it's reasonable to think that we could see above-average dividend growth for this upcoming decade. But you want to make sure it's healthy. There are the horror stories in the past of companies cutting their dividends completely or almost completely. General Electric would be the most prominent example in my mind. Here was this massive, the biggest company on the planet at one point, I think in the late 90s, but a venerated company that was paying a dividend, had great stock price appreciation in its history, ran into some hot water in the 2000s. They started to rely too much on the financial part of their business, especially

going into the global financial crisis in the last decade. They essentially paid their dividend too long, if you look at it. They paid their dividend, kept it high, really into 2009, even after the company had run into trouble. That really hurt the balance sheet. They did it because they felt that so much of their investor base, including tens of thousands of pensioners who own General Electric stock, really depended on that dividend. It forced the company to use a lot of that capital they badly needed to pay the dividend. It turned out to be a mistake, and that hurt the balance sheet. And if you look at General Electric as a business, it really has actually never recovered. And there are some dividend controversies

that could be looming, where you see some companies paying more dividends than they're making in earnings. And in some cases, there's some lawsuits on the horizon that they may want to watch. Absolutely, Ricky. Two companies come to mind in that zone, which is 3M, a great industrial company that many people are familiar with. they've paid a dividend for much of its history, and they have a nice yield right now. But they certainly have some big lawsuits coming that could result in billions of dollars worth of payouts. And my thinking there is that the dividend might get cut if some of those actually come to fruition. And then there's the company Hasbro, which is the iconic toy company.

They've paid a dividend for a long time as well, raised it, I think, nine out of the last 10 years. But if you look at their earnings, their earnings have really flattened out to the point where the dividend payout ratio is now exceeding 100%. I'm not exactly sure of the full story there, but that would strike me as worrisome that the dividend might get cut in the short term. It's a little bit like Lucy eating chocolates at the chocolate factory where you're raising your dividend, but you're not necessarily keeping up with your earnings. That's right. All right. This is 101. I got a dumb question because I'm a bit of a dumb guy. The way I think about dividend investments, or the way I thought of it without thinking much,

which is how I think about most things, is if you wanted an investment that paid you regular cash flows, and you want something that scratches that itch, why not focus on REITs? They have to pay out 90% of their income to shareholders. There's a little bit more complexity with how companies pay dividends. If you want regular cash flows as an investor, why not just buy up some REITs? I'm not going to argue with that, actually, because if you ask Anthony and me, we love REITs. The two services we work on at The Motley Fool recommend a lot of REITs, and we know the industry well. My only pushback there would be, even though you get that more, I don't want to say guaranteed, but you certainly get

higher payouts and higher dividends with REITs in general, just because of the way they're structured. If you invested only in REITs, you're only getting exposure to the real estate sector of the economy. You're ignoring the hundreds of other companies out there that are also paying dividends that touch many sectors like financials, utilities, healthcare, even technology stocks. You can find many that pay dividends nowadays. I love REITs, and I certainly own a lot of REITs, and I love them for their income potential, but there's certainly a wider opportunity set for you as an investor if you look outside REITs as well. We got a couple of technical questions, but I do think they're important. When you're collecting dividends, do you guys like reinvesting

them in the company or do you just take the cash? That's a good question. I probably am going to confuse a lot of listeners because I do the opposite of what I think most financial advisors might suggest. But in my retirement accounts, which are tax-deferred, I actually like to reinvest the dividends there in the companies. That's mainly because when I buy a company for my retirement account, I'm planning for it to be there for many, many years. I like the company. I'm fine with letting those dividends come in and then reinvest in a drip and buy those shares. When I look at my taxable accounts, where I also have dividend payers and REITs, I actually tend to take the cash instead of reinvesting the dividends. That's because I like to get the cash

and be a little more opportunistic about where I want to invest new capital. I might see better value in something else rather than investing back into the same company. That's my approach. Ant, what about you? Yeah. For me, I own most of my dividend-paying stocks in a retirement account. And I choose to reinvest all my dividends. Since I recently just started my investing journey, my dividend income still is pretty small. So my situation, I don't think it makes too much sense taking the cash. I'd rather allow that dividend income and capital appreciation to compound uninterrupted in the retirement account, and just stay invested the whole time. Now, in 10, 15, 20 years,

when my dividend income is larger, I think I may choose to take the cash and deploy it to the best available opportunity. But for right now, I think I'm just going to set it and forget it. All right. You're a newbie investor. You're in the 101 class, for goodness sake. Should you be leaning toward the dividend ETFs, exchange-traded funds? Exchange. Exchange. traded funds? Or do you like the individual dividend-paying stocks? We don't need to edit that, Rick. We can leave that in. The people love it. Well, we're The Motley Fool, right? And I think we're always, at The Motley Fool, going to lean towards individual companies, individual stocks, because they're more interesting. And I think, as do-it-yourself

investors, we like to build our own portfolios. But I think if you're just starting out, you don't have a lot of cash at your disposal, you're looking to get diversification, there are certainly some interesting choices if you're looking at index funds or ETFs. A few that come to mind, there's the Vanguard High Dividend Yield, the ticker is VYM, and that focuses on companies that pay above-average dividend yields. There's the Vanguard Dividend Appreciation Fund, which is VIG, and that focuses on companies that are growing their dividends over time. Then Anthony mentioned the dividend aristocrats earlier, which are companies that have paid or increased their dividend 25 years in a row, which is extraordinary.

Very few companies make that list. There's actually the ProShares S&P 500 Dividend Aristocrats ETF, and the ticker is NOBL. Got to love that. These are great low-cost ways to get started. I will point out though that these three ETFs that I mentioned, VOIM, VIG, and OBL, they've actually underperformed the broader market for quite a while now. I think that's understandable given the nature of the past bull market we were in, which was really about technology companies, software companies, companies that weren't paying dividends. I expect, and I think Anthony does as well, that they're going to do a lot better going forward. Ant, any thoughts on ETFs versus the individual stock approach? Yeah, I'm going to have to echo your

thoughts, especially on the Vanguard ETFs, because I think that's a great way and a low-cost, efficient way to get broad exposure and diversification, especially when you're just starting your investing journey. I know for me, the first investment I ever made was into a Vanguard low-cost index fund. And then from there, I started to build up my individual portfolio, because I knew I had that diversification through the index fund. All right. The people are hungry for some ideas. I can feel it. They've been listening to Dividend Basics for more than 20 minutes. Let's finish this off with some interesting companies paying a dividend right now. One could even call it, Matt, an interesting income

opportunity. I like that, Ricky. The two companies that come to mind for me right now, I don't think many people are going to think of them as dividend companies. Their dividend yields right now are relatively low. The first one is eBay. Needs no introduction. I'm sure many people on listening have heard of eBay and probably used eBay to buy and sell things. It's still a great e-commerce marketplace. It still has tens of millions of buyers, millions of sellers. It's got a lot of good things going for it. One of the things I love about it is just the amount of cash the company generates. The margins are just incredible. eBay has become a little bit of a dividend payer. They started paying a dividend, I think, about four years ago. They've already

raised it three times. I think the yield today is right around 2%. I figure this is going to be one of those companies where the dividend is going to become a lot more important to the company over time. We're going to see them raise that dividend. It's like an emerging dividend grower. The other company I'm thinking about is a company called Quest Diagnostics. DGX is the ticker there. This is a company that's essentially a duopoly in the area of lab testing and diagnostics, and huge competitive advantages. Another company that's growing their dividend and paying a dividend for a while now, they're growing it. One of those companies where I think it's going to become a great income opportunity. Both eBay and Quest Diagnostics, by the way, have fairly low payout

ratios, which means I expect as earnings grow, their dividends are going to grow nicely as well. Anthony, what you got? The first is EPR Properties. I just love their focus on experiential properties. They own a bunch of movie theaters, Topgolf, water parks. And at a time when there's so much pent-up demand for experiences coming out of the pandemic, I really like this play. It's really a first summer without any COVID-related restrictions. So, I think this is an interesting opportunity. They just recently got back into growth mode with a big acquisition in Canada. The stock yields about 7% right now, but that dividend is well covered. It pays out about 75% of its FFO, which is pretty well covered. At its current valuation, I think it's

a nice opportunity to capture yield and that capital appreciation. Two things I'd like to throw in, Ant, if I may, about EPR. It pays a monthly dividend, which is cool. If you're an investor who wants to get that dividend on a monthly basis, it's one of the few dividend payers REITs that pays on a monthly basis. Anthony mentioned FFO, funds from operations. With REITs, that's the key earnings metric you want to look at. When we mentioned payout ratio earlier in the show, we were talking about earnings payout ratio. In the REIT world, you want to look at FFO, which is more of the cash flow that's more appropriate to measuring real estate earnings. Just a quick pro tip there. Anthony Chavone, Matt Argersinger,

investors on the Mogul and real estate winter services for The Motley Fool. Thanks for joining us on the show. Thanks, Ricky. Thanks for having us. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.