Two Types of Dividend Paying Stocks

by JT McGee

Financial pundits often turn sour on whole groups of companies when commenting on the market. Whether its making a claim about the valuation of the 500 stocks in the S&P 500 index, or justifying a rally in a particular sector, everyone likes talking about whole sectors of the investment universe, rarely discussing the potential in an individual stock.

Dividend stocks are Wall Street’s new pariah. The bloodbath started once Bernanke let on that the Fed may slow quantitative easing, effectively giving the signal that income stocks are on their way out.

2 Types of Dividend Stocks

Discussing all dividend stocks as a group doesn’t make much sense. I separate dividend stocks into two major categories by their returns on invested capital, high and low.

To demonstrate the difference, here’s two examples: McDonald’s and Realty Income Corp. McDonald’s franchises its fast food business model to franchisees and holds land which it leases to its restaurant owners. Realty Income Corp. owns a bunch of real estate which it leases to businesses.

McDonald’s generates returns on invested capital between 15-20% in any given year. The high returns come from 1) the fact that low-return land only makes up a portion of each new investment and 2) the franchise model requires virtually no cash infusion on McDonald’s behalf for a new store to open.

So, for each $1 it pumps into its business model, McDonald’s can expect $.15-.20 in net income to come back out. Realty Income Corp. makes significantly lower returns on capital; it recently purchased a rival real estate investment trust at a yield of about 5.7%. Each dollar makes about six cents per year in net income.

Though both are dividend stocks, they have very different exposure to rising rates. If McDonald’s can deploy capital and earn 20% on every dollar invested, a minute change in rates has minimal effect on profitability or growth.

However, since Realty Income Corp. earns only about 6% on incremental capital, a rise in rates could severely cripple the economics of levered real estate. Unlike you and I, Realty Income Corp. doesn’t borrow on 30-year fixed terms. It borrows with varying bond issues of differing lengths and at different interest rates. When those issues come due, Realty Income has to refinance them at the new market rate.

See it in action

As rates rose, some dividend stocks got slaughtered. Some. Not all.

Only the very capital-intensive industries like real estate, and utilities were punished, as you can see by this chart of utilities (XLU), REITs (VNQ), an ETF of high ROIC dividend stocks (VIG), and the S&P 500 index (SPY).

Companies with high returns on invested capital (VIG) survived the storm just fine because they are not built on low return assets they have to leverage to get stock-like returns.

I’m not a dividend investor, so I really don’t have a dog in this fight. But I do think it’s important that that investors distinguish between companies that generate high returns on capital, and companies that generate low returns on capital. Low ROC/ROIC companies will get slaughtered when rates rise. High ROC/ROIC companies won’t. Whether or not they pay dividends is moot.

{ 2 comments… read them below or add one }

Joe June 15, 2013 at 12:20

JT good stuff, but you really should consider some dividend growth stocks for your portfolio. Some of the best companies raise their dividends and outperform the market by unbelievable margins: /case in point: GWW, MKC, CHD, CRI, VFC, V, SBUX, and on and on. The hardest part is finding them.

Regards,
Joe

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JT McGee June 16, 2013 at 14:38

I’m a deep value investor. Dividend stocks just don’t fit in with my criteria as they’re 2-3x more expensive on an earnings/cash flow basis. Here’s a look into the kind of stuff I own.

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