Dividend investing has long been hailed as a reliable strategy for generating passive income. By focusing on companies that return capital to shareholders, investors can enjoy steady cash flows and participate in the growth of high-quality businesses. However, the debate around dividends versus total returns, share buybacks, and broader investment strategies continues to evolve. In this article, I will dig deep into the nuances of dividend investing, exploring its advantages, pitfalls, and how it compares to alternative strategies like shareholder yield. Finally, I'll go through some dividend stocks that are largely in line with my dividend investing strategy, and could be good plays in the current market context.
The Dividend Investing Appeal: Income and Stability
Dividend-paying stocks are attractive for their tangible income and perceived stability, especially during market downturns. Companies that initiate or increase dividends often signal financial strength and confidence in their future earnings. Dividend growth investing, in particular, appeals to long-term investors by focusing on firms that consistently grow payouts. Such companies tend to have sustainable competitive advantages and disciplined management teams.
Dividend stocks are often viewed as defensive, with lower volatility during recessions, as they tend to belong to sectors like utilities, consumer staples, and healthcare. Historically, dividends have played a significant role in overall market returns. For example, high-dividend-yielding stocks have outperformed the broader market in several studies, proving that dividends can be more than just a side benefit—they're a core component of portfolio performance.
The Challenges: Myths and Missteps in Dividend Investing
Despite their appeal, dividend investing is not without pitfalls. A key misunderstanding is the so-called "dividend fallacy." Some investors mistakenly believe dividends offer bonus returns, failing to recognize that the stock price typically adjusts downward by the amount of the dividend payout. The total value of the investment remains unchanged, akin to breaking a full-size candy bar into smaller pieces without increasing the overall chocolate.
Other risks include:
- Dividend Traps: High yields can be deceptive. A declining stock price due to weak fundamentals can inflate the yield percentage, luring investors into struggling companies that may eventually cut dividends.
- Sector Concentration: Many dividend-focused portfolios lean heavily on certain sectors, such as utilities or financials, while underweighting growth-oriented sectors like technology, potentially limiting long-term growth opportunities.
- Tax Inefficiency: For investors still accumulating wealth, reinvesting dividends can trigger unnecessary tax events, making non-dividend-paying stocks more appealing from a tax perspective.
Beyond Dividends: The Shareholder Yield Advantage
Meb Faber, founder of Cambria Investment Management, has championed a more comprehensive approach to shareholder returns: shareholder yield. This metric combines dividends, share buybacks, and debt reduction to measure how much capital a company is returning to its investors. Faber argues that shareholder yield is a better indicator of value than dividends alone.
Companies have increasingly shifted toward share buybacks over the past few decades. Buybacks, though sometimes controversial, can be more tax-efficient than dividends. By reducing the number of outstanding shares, buybacks increase earnings per share (EPS) and enhance the value of remaining shares without triggering immediate tax liabilities for shareholders. For instance, Apple epitomizes the shareholder yield strategy. From 2013 to 2020, the tech giant not only paid dividends but also executed substantial buybacks, reducing its float significantly. These actions contributed to its strong performance and cemented its status as a model for capital allocation.
Faber's Cambria Shareholder Yield ETF leverages this strategy by screening for companies that combine strong shareholder returns with attractive valuations and high-quality fundamentals. The result has been impressive, with the ETF delivering a 12% annualized return over the past decade, outperforming its benchmark.
Dividend Investing in a Total-Return Context
A landmark study in 1961 laid the foundation for the total-return approach, which combines capital appreciation and income generation. Proponents argue that investors can create their own “dividends” by selling shares when needed, offering greater flexibility and tax efficiency. However, dividend investing offers behavioral advantages. Regular payouts provide tangible rewards, motivating investors to save and stay invested. This psychological benefit is particularly valuable for retirees, who can rely on dividends to meet living expenses without worrying about the timing of stock sales during volatile markets.
Dividend Stock Recommendations
For investors looking to pivot to a more dividend-oriented investment strategy, Coca-Cola and Kraft Heinz are excellent choices. Coca-Cola's robust global brand and history of dividend growth make it a stable, long-term investment (one of Buffet's long-time holdings as well). Meanwhile, Kraft Heinz's high yield and focus on operational improvements offer significant income potential, particularly for value-oriented investors.
1. Coca-Cola (KO, Financial): The Quintessential Dividend Stock
Coca-Cola is a stalwart in the world of dividend investing, having delivered consistent and growing payouts to shareholders for more than six decades. The company's enduring profitability, dominant global presence, and proven ability to navigate economic cycles make it a cornerstone of any dividend-focused portfolio.
Dividend Leadership: Coca-Cola's reputation as a Dividend King is well-earned. With a dividend growth streak spanning 62 consecutive years, the company offers unmatched reliability. Its current forward dividend yield of 3.1% is marginally above the consumer staples sector median, and its payout ratio of 68% strikes an ideal balance between rewarding shareholders and reinvesting for growth.
Resilient and Growing Financials: The company's third-quarter 2024 results further underscore its appeal. Despite a 0.8% decline in net revenue to $11.9 billion—primarily due to a 5% impact from unfavorable foreign currency translations and a 4% drag from refranchising bottling operations in key markets—Coca-Cola demonstrated its resilience. Organic revenue surged 9%, driven by a 10% growth in price and mix, including a 7% boost from strategic pricing initiatives. Additionally, stronger growth in developed markets offset some of the challenges in emerging markets. Coca-Cola's non-GAAP earnings per share (EPS) rose by 4.1% year-over-year to $0.77, exceeding analyst expectations by $0.02. This growth was fueled by disciplined cost management, which expanded the company's non-GAAP net profit margin by 140 basis points to 28.2%. Coca-Cola's guidance for the full year indicates non-GAAP EPS growth at the top end of its 5% to 6% range, translating to $2.85 per share—consistent with analyst consensus.
Valuation and Growth Opportunities: After a 13% decline in its stock price over the past three months, Coca-Cola is trading at an attractive forward EV/EBITDA multiple of approximately 20x. Historically, its EV/EBITDA ratio has fluctuated between 16x and 24x, suggesting the current valuation is at the lower end of the range. This provides an enticing entry point for long-term investors. The company's product portfolio, spanning 800 billion annual servings worldwide, offers significant growth potential. Only 30% of developed-market consumers currently drink Coca-Cola products weekly, highlighting substantial untapped opportunities. Emerging markets also present a large runway for expansion as incomes rise and consumer preferences evolve.
A Trustworthy Dividend Growth Machine: Coca-Cola's dividend growth trajectory is poised to continue, supported by its manageable payout ratio and steady earnings growth. With a forward EPS payout ratio in the high 60% range, the company has ample flexibility to increase its dividend in line with future profit gains. This ensures Coca-Cola remains a dependable income-generating asset for years to come.
2. Kraft Heinz (KHC, Financial): A High-Yield Opportunity
Another staple in Berkshire Hathaway's portfolio, Kraft Heinz offers an attractive forward yield of 4.75%. Despite facing challenges from inflation and weak consumer spending, the company's focus on cost-cutting and emerging markets positions it for long-term growth. Kraft Heinz owns iconic brands like Heinz ketchup and Oscar Mayer, generating steady cash flows even in tough economic conditions. Management's commitment to maintaining a 40-cent quarterly dividend and improving margins underscores its shareholder-friendly approach.
Buybacks and Financial Strength: As a dividend investor, it is reassuring to see Kraft Heinz conducting share buybacks. These buybacks not only enhance earnings per share over time but also strengthen dividend safety by reducing the total number of shares outstanding. This underscores the company's financial strength, as it demonstrates the ability to return capital to shareholders even after meeting dividend obligations. Trading near its 52-week low of $30.68, Kraft Heinz presents an attractive opportunity. Management authorized a $3 billion buyback plan late last year, with $329 million worth of shares repurchased in 2023.
Dividend Safety: Although Kraft Heinz cut its dividend in 2019 and has maintained a quarterly payout of $0.40 since then, the starting yield of 5% remains appealing, particularly for long-term investors. Over the past three years, the company's free cash flow has averaged approximately $3 billion, compared to $1.96 billion in dividend payouts. This leaves about $1 billion annually for reinvestment or further share buybacks. In the latest quarter, Kraft Heinz paid out $486 million in dividends while generating $477 million in free cash flow, an improvement of over 116% from the prior year. While higher capital expenditures offset some of this growth, the company's financial position remains solid.
Valuation and Growth Potential: At a current price of $31.87, Kraft Heinz's forward price-to-earnings (P/E) ratio of 10.49x is significantly below the sector median of 18.53x and peers like Hershey (18.81x) and General Mills (13.89x). Wall Street's price target of $40.38 implies a potential upside of nearly 27%, offering substantial growth alongside its robust dividend. Additionally, Kraft Heinz's two-year forward EPS outlook is positive, supported by a focus on technological advancements and cost efficiencies. Investors stand to benefit from both capital appreciation and a generous 5% yield while waiting for upside to materialize over the next 12-24 months.
