(Updated Jan. 19 by The Financial Canadian)
As dividend growth investors, it is often easy to get caught up in the trap of "chasing yield" – investing in the highest-yielding stocks without regard to any other financial metrics.
However, this is not always the best approach.
Chasing yield can result in investing in companies that are paying unsustainable dividends, which can often lead to one or more dividend cuts.
Dividend cuts are one of the worst things that can happen to a dividend growth investor.
They are poorly received by the market in general and seen as a sign of management incompetence and business weakness.
Low-yield dividend stocks (in general) are less likely to cut their dividends because they have lower payout ratios – and are often growing faster. This gives them more "wiggle room" to continue paying rising dividends, even in difficult business environments.
In this article, "low-yielding dividend stocks" will be defined as stocks that pay a dividend but whose yield is below 2%.
There are a variety of low-yielding dividend stocks that are appealing investments right now. These stocks will be described in brief at the end of this article.
The relationship between quality and dividend yield
Often, a company’s low yield says nothing about the quality of the underlying business.
The relationship between quality and yield is essentially nonexistent – unlike the relationship between business quality and dividend increases, which is a strong sign of shareholder-friendly management.
For an example of how yield and quality can diverge, consider Johnson & Johnson (JNJ, Financial), a prime example of a high quality stock.
Last year, the company marked 32 consecutive years of growth in earnings per share. Its stock price has one of the lowest volatilities (as measured by standard deviation), and the company has a tremendous record of dividend growth. They are also one of only two U.S. companies to hold the coveted AAA credit rating from Standard & Poor's.
To be a Dividend Aristocrat, a company must pay 25-plus years of rising dividends. Johnson & Johnson matches this qualification more than twice over.
Incredibly, the company has increased dividends for 54 consecutive years. This makes it a member of the elite Dividend Kings – stocks with 50-plus years of consecutive dividend increases.
By many measures (earnings, volatility, dividend increases), Johnson & Johnson is a high quality company. I am not the only one who thinks this – Johnson & Johnson is the third-most popular stock among dividend growth bloggers.
Right now, Johnson & Johnson is not a low-yield dividend stock. The company currently pays an 80-cent quarterly dividend, which equates to $3.20 annually. Based on its current stock price of $114.87, the company has a forward dividend yield of 2.8%. This is 40% above the 2.0% dividend yield of the S&P 500 Index.
Now imagine for a moment that Johnson & Johnson suddenly releases a new product that is expected to transform the industry and generate massive profits for the company. The stock price surges as a result, trading up to $180. This in turn reduces the company’s dividend yield to 1.8%, classifying it as a low-yield dividend stock according to this article's 2% cutoff.
Does this mean the quality of Johnson & Johnson’s underlying business has suddenly decreased because its dividend yield has? Absolutely not!
While changes in dividend yield may be indicative of changes in company valuations, it has no effect on the quality of the underlying business.
Low-yield stocks are neither better or worse than higher yielding stocks.
The benefits of retained earnings
Lower dividend yields are accompanied by lower payout ratios, all else being equal. Lower payout ratios mean that the company is retaining more of its earnings to drive growth.
With retained earnings, companies can perform a variety of actions that are beneficial to their business (and shareholders):
- Hire more (or better) talent, increasing the human capital under the company's roof.
- Invest in new plant, property and equipment.
- Increase R&D budgets, increasing the company’s intellectual property (IP) portfolio.
- Repurchase shares, another method of returning cash to shareholders.
Generally speaking, young companies in the early stages of their business trajectories are more likely to retain earnings for growth. These retained earnings are generally used to drive earnings-per-share growth, which increases the company’s stock price if price-earnings (P/E) ratios remain constant.
All other things being equal, stocks that retain more of their earnings will grow faster because they have more money to invest into growth projects.
As a result, the total return of low-yield dividend stocks is boosted more by stock price increases and less by dividend payments. Depending on the exact scenario in question, this may result in beneficial tax treatment for investors.
Tax benefits
Another advantage of investing in low-yielding dividend stocks is its effect on taxation. When investors are paid dividends by the companies they own, they must pay tax on the dividends immediately.
This is not the case with the capital gains tax.
For readers unfamiliar with the term, a capital gain occurs when a security is sold for more than it was purchased. If an investor purchased shares of Abbott Laboratories (ABT, Financial) in June for $36.95 and sold them today for $40.90, a capital gain of $3.95 per share would be incurred (the difference between the purchase price and the sale price).
For tax purposes, capital gains are only recognized the moment the security is sold. This is called a "realized" capital gain. Before the sell, the potential capital gain can be referenced by calling it an unrealized capital gain.
This means that investors can defer taxes by holding onto stocks for a longer period of time.
“The single greatest edge an investor can have is a long-term orientation.” – Seth Klarman (Trades, Portfolio)
While long-term investing has many other benefits, including reduced brokerage fees, one of the more substantial is the deferral of capital gains taxes. And this effect is magnified in low-yield dividend stocks since most of their total returns come from stock price appreciation.
For illustrative purposes, consider an extreme example:Â Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). The company does not pay a dividend because it is led by one of the most skilled capital allocators in history, Warren Buffett (Trades, Portfolio).
Buffett is arguably the greatest investor of all time, and this is reflected in the performance of his business. The company has delivered phenomenal total returns over the years.
Those returns would be dramatically impacted if investors were to sell and repurchase their Berkshire stock each year (triggering a taxable capital gain). Deferring these cumulative taxes until the end of a holding period is a large boost to investment performance.
Applying a 20% capital gains tax to each year of positive returns (capital losses are not taxable and are actually applied against capital gains from other securities) yields the following results:
Source: Yahoo! Finance (Note that this is for Berkshire’s Class A shares)
As expected, applying capital gains taxes each year detracts from results in any year where Berkshire Hathaway’s returns were positive. What isn’t expected, though, is the huge effect these taxes have when they are compounded over the long term.
Source: Yahoo! Finance
A slightly lesser effect can be seen in low yield dividend stocks.
However, capital gains tax deferral is more noticeable in low-yield dividend stocks than in high-yield dividend stocks (all else being equal). Since a smaller proportion of the total return for these stocks is from their dividends, more taxation is deferred until the security is eventually sold.
Examples of high-quality, low-yield dividend stocks
It’s not hard to look around and find examples of high-performance, low-yielding dividend stocks. There are currently two low-yielding dividend stocks that rank in the top 10 using The 8 Rules of Dividend Investing. These are:
- Hormel Foods (HRL, Financial) (yield of 1.9%)
Source: Sure Dividend Newsletter
- The Walt Disney Co. (DIS, Financial) (yield of 1.4%)
Source: Sure Dividend Newsletter
For these two companies, low dividend yields are not an isolated phenomenon. Both of these companies have historically had dividend yields below 2% for extended periods of time. They have also spent a lot of time in the Top 10 of the Sure Dividend Newsletter, which indicates their appealing investment prospects according to The 8 Rules of Dividend Investing.
A few other high-quality companies with low dividend yields are:
- Walgreens Boots Alliance (WBA, Financial).
- General Dynamics (GD, Financial).
- Sherwin-Williams Co. (SHW, Financial).
Although these companies do not currently rank in the Top 10, they still have strong investment prospects despite their low dividend yields.
To conclude this article, I will give a brief overview of each of these companies, along with their performance relative to the S&P 500 over a five-year time period.
We will see that each of these stocks has had very strong total returns in spite (or perhaps because) of their low dividend yields.
Low-yield example No. 1: Hormel Foods
Hormel Foods had very humble beginnings. Hormel’s history can be traced back to 1891, when the company’s founder, George A. Hormel, started operations in Austin, Minnesota. By 1910, the company was planning nationwide expansion and by 1926, Hormel had developed the world’s first canned ham.
Today, Hormel Foods is a giant in the packaged foods industry. Its market leadership includes having 30 products that hold No. 1 or No. 2 market share in their respective categories.
This creates a unique competitive advantage due to extensive brand equity built up over time. While many companies have a few market-leading products, Hormel has 30.
Hormel’s business is structured into five different operating segments:
- Refrigerated Foods (50% of sales).
- Jennie-O Turkey (18% of sales).
- Grocery Products (17% of sales).
- Specialty Foods (9% of sales).
- International & Other (6% of sales).
The following illustration outlines many of the more popular brands under the Hormel Foods umbrella. Chances are some of these brands currently inhabit your cupboard.
Source: Hormel Foods website
The strength and diversity of the company’s business model is evident in its dividend history. There are very few businesses that can match its record of increasing distributions to shareholders. Hormel Foods has 50 consecutive years of dividend increases, making it a Dividend Aristocrat and a Dividend King.
Despite this steady dividend growth, Hormel is a low-yield dividend stock with a current yield of 1.9%.
It is one of many low-yield stocks to have dramatically outperformed the S&P 500 over the past five years.
Source: Yahoo! Finance
Investors who purchased Hormel five years ago have enjoyed total returns of 166% (compared to the S&P 500’s 76%).
Low-yield example No. 2: Walt Disney
Disney is one of the most well-known names in the global media industry. The company has been all over headlines in recent times due to its many blockbuster movies recently brought to market, including "Star Wars: The Force Awakens" and "Captain America: Civil War."
Disney’s operations are divided into five segments for reporting purposes, listed below along with their contributions to operating income in fiscal 2015.
- Media Networks earned 53% of operating income.
- Parks & Resorts earned 21% of operating income.
- Studio Entertainment earned 13% of operating income.
- Consumer Products earned 12% of operating income.
- Interactive earned 1% of operating income.
Disney’s Media Networks business is by far its largest segment. The rest of its operations are reasonably well diversified among Parks & Resorts, Studio Entertainment and Consumer Products with the Interactive segment barely moving the needle on the company’s operating income.
Compared to the other companies in this article, Disney has a weaker dividend history with six years of consecutive dividend increases. It is less surprising to see that Disney’s dividend yield of 1.4% makes it a low-yield dividend stock.
Regardless of its Mickey Mouse-sized dividend yield, the company has crushed the S&P 500 Index over a five-year time horizon.
Source: Yahoo! Finance
Disney’s investors have enjoyed five-year total returns of 196% (more than twice the S&P 500’s 76% benchmark).
Low-yield example No. 3: Walgreens Boots Alliance
Walgreens Boots Alliance was created in 2014 due to the sizable merger between Walgreens and Alliance Boots. The merger joined two complimentary businesses: a large drugstore chain in the U.S. (courtesy of Walgreens) with a major European retail pharmacy, wholesaler and distributor (courtesy of Alliance Boots).
Now, the company is a behemoth in its industry. Walgreens Boots Alliance has nearly 13,000 stores across 25 countries and more than 370,000 employees. Its operations are diversified across geographies, with a significant company presence in North America, South America, Europe and Asia.
Source: Walgreens Boots Alliance Investor Presentation, slide 17
Fiscal 2016 was a successful year for Walgreens Boots Alliance. Its sales were up 13.4% (or 16.0% on a constant currency basis), and its adjusted earnings saw growth in excess of 18%.
Source: Walgreens Boots Alliance Investor Presentation, slide 13
Walgreens Boots Alliance has an impressive dividend history that is driven by its strong business performance. Including its predecessor company Walgreens, 2016 marked the company’s 41st consecutive dividend increase, making Walgreens Boots Alliance a Dividend Aristocrat and a Dividend King.
Walgreens’ 1.8% dividend yield certainly doesn’t make it a high-yield dividend. Like the other stocks mentioned in this article, its low yield hasn’t prevented it from outperforming the overall stock market during the past five years.
Source: Yahoo! Finance
Walgreens is yet another example of a low-yield dividend stock with a high quality underlying business. Its retained earnings have driven total returns for shareholders: Over the past five years, the stock has returned 178%, well above the 76% returned by the S&P 500.
Low-yield example No. 4: General Dynamics
General Dynamics is one of the largest military and defense contractors in the U.S. In fact, there are only three companies in this industry larger than General Dynamics:
- Boeing (BA, Financial) ($98 billion market cap).
- United Technologies (UTX, Financial) ($90 billion market cap).
- Lockheed Martin (LMT, Financial) ($74 billion market cap).
- General Dynamics ($54 billion market cap).
General Dynamics’ operations are diversified into four segments for reporting purposes, listed below:
- Aerospace (28% of 2015 sales).
- Combat Systems (29% of 2015 sales).
- Marine Systems (25% of 2015 sales).
- Information Systems & Technology (18% of 2015 sales).
General Dynamics possesses a strong competitive advantage due to the nature of its earnings mix. A large proportion of its revenues are contracts with the Department of Defense.
Source: General Dynamics 2015 Annual Report, page 8
The company also has strong growth prospects due to its immense backlog of future business. This backlog is diversified across each of its four business segments, and a large proportion of it is already funded.
Source: General Dynamics 2015 Annual Report, page 10
General Dynamics has been paying uninterrupted dividend payments to shareholders since 1979. Further, 2016 marked the company’s 25th year of consecutive dividend increases. This makes the company one of the newest Dividend Aristocrats.
Despite its growing dividends, General Dynamics retains most of its earnings to fund organic growth. The company’s dividend yield of 1.7% is less than the S&P 500’s dividend yield of 2.0%, but this has not stopped General Dynamics from seriously outperforming the index over the past five years.
Source: Yahoo! Finance
Investors who have owned the company over the past five years have benefited from total returns of 176%.
Low-yield example No. 5: Sherwin-Williams
Sherwin-Williams can trace its humble beginning to 1866 in Cleveland. The company’s co-founders, Henry Sherwin and Edward Williams, were the inspiration for the company’s name.
After a century and a half of profitable business, Sherwin-Williams is now the undisputed leader in the North American paints and coatings industry. Many of its products are household names, including:
- Sherwin-Williams.
- Dutch Boy.
- Krylon.
- Minwax.
- Thompson’s Water Seal.
Sherwin-Williams’ operations are divided into four segments for reporting purposes:
- Paint Stores Group.
- Global Finishes Group.
- Consumer Group.
- Latin America Coatings Group.
Source: Sherwin-Williams Investor Presentation
Based on revenue, the company’s Paint Stores Group is the largest, followed by Global Finishes, Consumer and Latin America. The contributions of these groups' revenues and operating profits are outlined in the following insightful diagram.
Source: Sherwin-Williams Investor Presentation
Sherwin-Williams has a strong track record with 37 years of consecutive dividend increases, which makes the company a Dividend Aristocrat.
But the shareholder-friendliness of Sherwin-Williams does not end with its dividend history.
For dividend investors looking to grow income over time, Sherwin-Williams is one of 15 Dividend Aristocrats that offers a no-fee DRIP. This provides a cost-effective method of increasing the dividend stream from this company over time.
Sherwin-Williams is a low-yield dividend stock with a current forward dividend yield of 1.2% (the lowest featured in this article). Interestingly, Sherwin-Williams' five-year total returns are actually the highest among the companies covered in this article.
Source: Yahoo! Finance
Sherwin-Williams' five-year total returns of 213% are almost triple the S&P 500’s 76%.
Final thoughts
This article has explored the merits of holding low-yielding dividend stocks. The benefits are numerous.
First, dividend yields are not necessarily correlated with the quality of the underlying business. Many high-quality companies have low dividend yields but tremendous track records of delivering value to shareholders. This is because of the companies’ competency with which they deploy capital – as long as management is confident it can earn a higher return on capital than its shareholders, then its reinvestment of earnings is justified.
Low-yield dividend stocks are also more tax favorable if an investor is willing to hold for the long term. This is due to the nature of capital gains tax – since these taxes are only paid upon the sale of a security, investors have the liberty to defer them indefinitely.
This article outlined five low-yield dividend stocks that have outperformed the S&P 500 Index over a five-year time horizon. Hormel, Disney, Walgreens, General Dynamics and Sherwin-Williams all have dividend yields below 2% but still present compelling investment opportunities at the right valuation.
Keep this in mind the next time you’re assessing the dividend yield of a potential stock purchase. Higher is not always better!
Disclosure: I am long Disney.
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