How to Evaluate Dividend-Paying Stocks

08/06/2012 9:00 am EST

Focus: FUNDS

Fund manager Bruce Zessar discusses his firm's Dividend Focus Strategy, which capitalizes on today's low-interest-rate environment. He details the approach Advisory Research uses to select investment opportunities.

Kate Stalter: Today, my guest is Bruce Zessar of Advisory Research. He's a co-manager of the All-Cap Value Fund (ADVGX).

Bruce, you were telling me you've also recently started a dividend focus strategy. Maybe you can just set the stage for us today, and give us a brief overview of each one of these first.

Bruce Zessar: Sure, that would be great. Advisory Research has been managing money since 1974. We have about $8.5 billion under management.

Our all-cap value strategy is a strategy that we launched about ten years ago. It's not market-cap constrained, so we can go wherever we find good value. And again, it's a value focus. Our firm has always had a value focus.

More recently, we launched a dividend strategy focusing specifically on what I call high-quality large cap companies that have a consistent return of capital to shareholders, both through dividends and share repurchases. So, those are a couple of the strategies that we run here.

Kate Stalter: Let's talk a little bit about the new one, and why you decided to get that one started at this point in time.

Bruce Zessar: We decided to launch the Dividend Focus Fund because we thought there was a real opportunity with the record low interest rates to focus in on a part of the market that we think is highly attractive.

That, in particular, are the high-quality companies that you know, you've seen, you've touched their products, like the McDonald's (MCD) and the Johnson & Johnsons (JNJ) of the world. They have very attractive dividends. They may be buying back their stock, so they're giving a lot of money back to shareholders. And in a low-interest-rate environment, you have a combination here of both getting a return of capital from the company, as well as the possibility for capital appreciation.

The contrast of what you can get from these companies-relative to what you can get, for example, in the fixed-income market-is much starker than it has been in the recent past. And we thought it presented a very attractive opportunity to start this fund.

Johnson & Johnson is a great example of a company that's been raising their dividend for decades. And if you look today, Johnson & Johnson is yielding about 3.5%; that's their dividend yield.

And Johnson & Johnson also has some long-term bonds trading in the market. It has bonds that are maturing in 2021, and if you look at those, those are yielding less than 2% today, down around 1.6%. So what I'm going to tell you is that it's been unique to have that kind of change in yield. Usually, the bonds have yielded more than the stock.

So if you look at it and say...imagine you only have two choices in an investment for the next ten years. You can buy this bond of Johnson & Johnson and you're going to get about 1.6%. And they should be money good for that, because they're rated AAA and the US government's rated AA+ right now. So, Johnson & Johnson, at least according to the rating agencies, is a better bet than the government.

So, you're going to get 1.6% on that, or you can take a flier on the Johnson & Johnson stock and get a 3.5% dividend yield, and that dividend is growing year-over-year. And I'll tell you that Johnson & Johnson, at roughly 13 times earnings, is at a reasonable multiple. So that if you look out ten years from now, Johnson & Johnson stock should, hopefully, be trading at higher than its current quotation, which is around $68. But you know, maybe if it was trading at the same amount, you're still going to get that dividend yield every year.

My point is that, with Johnson & Johnson stock, you can earn roughly 2% more a year than you're going to earn on their bond. To us, that presents an attractive of yield for an investor. And the possibility for capital appreciation and these kinds of opportunities hadn't existed prior to the financial crisis.

You know, ten-year bond yields were up in the 5% range, maybe higher for high-quality corporations. And their dividend yields may have been around 3%, but it was reversed. Now you've got this opportunity where you can earn more by owning the stock than by owning the bond.

Kate Stalter: A moment ago, you mentioned the idea of capital appreciation in these stocks as well. Talk about your strategy for getting total return-how you're identifying the best candidates for that combination of dividend yield and price appreciation.

Bruce Zessar: Well, it's a combination of things. One, the dividend yield and the consistency of raising the dividend, and in coverage of the dividend. For example, the payout ratio, and then, of course, valuation. You know, a company that may be trading at 30 times earnings probably isn't something that's going to excite us.

You want to look at three components. You want to look at the yield, you want to look at the earnings and dividend growth, and then you want to look at valuation. And you can kind of add these metrics up to get a guesstimate-nobody knows what's going to happen in the future--but an estimate of what you think you may be able to earn looking out ten years or so.

If the dividend yield on Johnson & Johnson is 3.5%, and they've been growing earnings in their dividends-let's just say at least high single digits a year over a ten-year period-and we say the valuation is reasonable around 13 times earnings...ten years out, if you combine those three things together, you should say, "Well, I should get a 3.5% dividend yield, and hopefully let's say 7% or 8% growth per year in earnings and dividends."

Then, if the P/E ratio stays the same, I'm not going to gain or lose anything in terms of the multiple, the valuation expanding or contracting. So you add those three components together, and you come up with an 11% possible return. The 3.5% dividend yield, plus 7% or 8% in earnings and dividend growth, and assuming no change in valuation-P/E ratio stays roughly the same-that's a good way of estimating that you have a pretty attractive return opportunity in this environment.

Kate Stalter: Your company is known for its mutual funds. Is this one also in mutual-fund format, or is it separately managed accounts? How is this structured?

Bruce Zessar: Well, the All-Cap Fund is in a mutual-fund format and the ticker is the Advisory Research All-Cap Value Mutual Fund (ADVGX). But the Dividend Focus Fund we offer in a separate account right now. We have not made it into a mutual fund yet.

Related Reading:

https://www.moneyshow.com/articles/DailyGuru-28648/2-Stock-Value-Metrics-That-Make-Sense/

https://www.moneyshow.com/articles/tptp080212-28730/10-Timely-High-Quality-Income-Stocks/

https://www.moneyshow.com/articles/Charts09-28719/3-Winners-if-Europe-Recovers/

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