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A Quality Dividend Solution
Matthew W. Gries, Director—New Product Development, Morningstar Indexes
Warren Miller, CFA, Head of Quantitative Research
Joshua J. Peters, CFA, Director of Equity—Income Strategy
Originally published in the 2012/13 Morningstar Indexes Yearbook
Screening with Morningstar metrics reveals income opportunities from competitive companies
through the Morningstar Dividend Yield Focus Index .
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Dividends play a critical role in long-term returns for equity
investors. Now, as ever, they provide a tangible link between
a share of stock and its intrinsic value. Though this point
has often been lost in the speculative bubbles of recent decades
(in which low dividend yields have correlated with low total
returns), the fact remains that the bulk of real total returns on
equities is provided by dividend income, not capital gains.
The reason dividends work is no mystery. Dividends are typically
an indication that a company has “arrived”—that its business
is well established, financially healthy, and both willing and able
to return cash to shareholders. Dividends also impose muchneeded discipline on corporate executives and directors: Having
undertaken a commitment to provide shareholders with
dividends, they are unlikely to be withdrawn on a whim.
Maintaining a meaningful and growing dividend also
obligates management to take a genuinely long-term view
of the business.
Dividends also provide significant financial flexibility for
shareholders. A dividend is always a positive contributor to total
return—a key advantage in light of the unpredictable nature
of capital gains and losses. Retirees and other investors who
need to meet ongoing obligations with their savings benefit
from steady inflows of cash. Other investors can reinvest dividends, building up the future value and earning power of their
Figure 1. Growth of a $10,000 Investment: U.S. Market Dividend Payers vs. Non-Dividend Payers (Dec. 14, 2000–Feb. 1, 2014)
U.S. Dividend Payers
U.S. Non-Dividend Payers
25,000
20,000
15,000
10,000
USD
5,000
2001
2002
Source: Morningstar
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
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Morningstar Indexes 2014 15
portfolios. In any event, anyone can appreciate having
shareholders, not management, control part of the cash flows
from the underlying business.
These benefits are borne out in the data. Academic and other
research has shown that dividend-paying stocks outperform nonpayers over long periods and—critically—that high-yielding
stocks outperform low-yielders. (See The Future for Investors by
Jeremy Siegel, 2005, and The Strategic Dividend
Investor by Daniel Peris, 2011.)
At the same time, not all dividends (let alone the firms that pay
them) are created equal. Dividends are not guaranteed, and
indeed are last in line to be paid out of a corporation’s resources.
Under financial stress a company’s stock price may plunge, and
its yield soar, only to end in an unfavorable action that delivers
neither the income nor the capital preservation or growth
that investors sought. Dividends that fail to grow at least as fast
as inflation present a separate threat, as purchasing power
diminishes over time.
The ideal dividend strategy seeks safety for dividend income as
well as dividend growth; with both, the investor may also
reasonably expect capital appreciation in line with the growth
of dividend payments over the long run.
Dividend investing has been lucrative in the new century.
As Figure 1 illustrates, a $10,000 investment made in the broad
U.S. market of non-dividend-paying stocks in December 2000
was worth $16,824 in February 2014. That same in­vestment
made in a broad index of all dividend-paying stocks, in contrast,
was worth $21,059.
It Pays to Look Under the Hood
Constructing a high-income portfolio of dividend-paying stocks
can be tricky. Simply choosing stocks with the highest dividend
yield can often result in the purchase of highly risky stocks
that are priced low relative to their dividends, due to potential
financial distress.
The quality of a firm’s business and a look at its financial health
can shine a light on a company’s ability to sustain its dividend
payment. At Morningstar, we use a number of proprietary
metrics to gauge the quality and financial health of a business.
Combining the Morningstar Economic Moat Rating with
the Distance to Default score and Uncertainty Rating can help
put together a portfolio of companies with consistency in
dividend payments and above-average performance. Below we
discuss the methodology of the Morningstar Dividend Yield
Focus Index and analyze the strength and predictability of each
of the three proprietary metrics mentioned above in screening
high-quality, dividend-paying businesses.
Morningstar Dividend Yield Focus Index
The Morningstar Dividend Yield Focus Index is a portfolio of
high-quality and high-yield stocks screened for consistent
records of dividend payments and the ability to sustain them in
the future. It is designed with the objective of capturing the
performance of companies that generate stable dividends by
focusing on high-quality businesses. The index consists of
75 stocks that are weighted in proportion to the total pool of
dividends available to investors.
The Morningstar Dividend Yield Focus Index is a subset of the
Morningstar® US Market Index, a broad market index
representing 97% of U.S. equity market capitalization. We apply
quality screens to the Morningstar US Market Index to arrive at
the constituents for the Morningstar Dividend Yield Focus Index.
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Quality Matters
We gauge the quality of dividend-paying companies with three
measures: a company’s Economic Moat Rating, its fair
value uncertainty rating, and its Distance to Default score.
The Morningstar Economic Moat Rating is an analyst-driven
rating that describes the sustainability of a company’s future
economic profits. We define economic profits as returns
on invested capital over and above our estimate of a firm’s cost
of capital, or weighted average cost of capital. Only firms
with economic moats—something inherent in their business
model that rivals cannot easily replicate—can stave off
competitive forces for a prolonged period. Companies can be
rated wide, narrow, or no moat, with wide-moat ratings
being relatively scarce—only 10% of Morningstar’s 1,500company coverage universe makes the cut. There are
two major requirements for firms to earn either a narrow or
wide Economic Moat Rating: the prospect of earning
above-average returns on capital, and some competitive edge
that prevents these returns from quickly eroding.
A Quality Dividend Solution
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Figure 2. Distribution of Dividend Cuts by Distance to Default Risk
Very Low
Low
Medium
High
1.0
0.8
0.6
0.4
0.2
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
(Monthly)
2010
0
Like the Economic Moat Rating, Distance to Default is a
successful predictor of dividend cuts. We clustered companies
into four groups based on the mean and standard deviation
of Distance to Default scores. Group one, or high probability of
default, has scores less than one standard deviation from the
mean score. The second group, or medium probability of default,
has scores greater than or equal to one standard deviation up
to the mean. Low and very low probability groups were constructed in the same fashion. A company in the high probability
of default group is eight times more likely to experience a
dividend cut in the following year than a company in the low
probability of default group.
Source: Morningstar
Although originally designed to characterize a firm’s competitive
strength, the Morningstar Economic Moat Rating has
also proven predictive of dividend cuts. These results appeal
to intuition because less competitive firms are inevitably
more susceptible to exogenous shocks that can result in more
frequent and larger dividend cuts.
We also measured the average size of the reduction for companies that cut their dividends in the year following the given
moat rating. This showed that no-moat companies cut their
dividend in the year following their rating assignment on average by nearly 70%. We applied a similar process for evaluat­ing
the Uncertainty Rating. On average, 2.3% of low-uncertainty
companies had a dividend cut within one year of the rating
assignment, compared with 15% of companies rated extremely
uncertain. Therefore, the Uncertainty Rating can be a good
predictor of a company that will be able to maintain its dividend.
Furthermore, the size of the dividend cuts can also be inferred
based on the Uncertainty Rating. We found that companies with
low Uncertainty Ratings cut their dividend in the year following
the rating assignment by 50.4% on average, compared to
more than 80% for companies with extreme Uncertainty Ratings.
Morningstar’s market-driven Distance to Default score uses
option pricing theory to evaluate the risk that the value of a
company’s assets will turn out to be less than the sum of its
liabilities. Distance to Default ranks companies on the likelihood
that they might encounter financial distress. The more likely
the value of a company’s assets is to fall below the sum of its
liabilities and a small capital cushion, the greater its
likelihood of financial distress.
Figure 3 displays the average likelihood of dividend cuts within
the year following a given Distance to Default group for all
dividend-paying companies. For example, 26.2% of dividendpaying companies that had a high probability of default at any
point in our study had a dividend cut within the following year.
Distance to Default is a strong predictor of dividend cuts; as
the probability of default increases, the probability of a dividend
cut moves in step.
Figure 3. Frequency of Dividend Cuts by Distance to Default Risk
Distance to Default Risk
High
Frequency of
Dividend Cuts %
26.2
Medium
8.9
Low
3.6
Very Low
3.0
Data over a one-year period, as of March 2011.
Source: Morningstar
More Than Yield Alone
Dividend investing can solve many investment challenges. But
investing with an eye toward yield alone—with no measure of
company quality—can lead to a poor risk/return trade-off. K