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By Billy Hwan, Portfolio Manager, Parnassus Value Equity, Senior Analyst and Krishna Chintalapalli, Portfolio Manager, Parnassus Value Equity, Senior Analyst

Identifying Value Stocks with Sustainable Dividend Payouts

It’s a good problem when you have enough cash available at the end of the month to choose how to use it. Should you invest for the future? Or take some of it to spend on something now? In the best situation, you can do both.

Generating abundant cash flow is one of the signals of a quality company. But how the company decides what to do with that cash can also offer insight into its management’s decision making and its confidence about future prospects. It can reinvest in the core business, expand the business through acquisitions, repurchase outstanding stock shares to help boost the stock price and, of course, pay dividends to shareholders.

The ways a company allocates capital can also send important signals about its quality. When a company is focused on paying out a solid dividend, it is less likely to squander excess cash in potentially unfruitful investments in the business.

For investors, dividends can be an appealing way to generate income. They can offer an important source of returns during periods of rising rates and volatile markets. And when re-invested, they can compound to drive long-term returns. In fact, dividends have contributed around 30% of long-term returns to the S&P 500 over the past century, according to S&P Global._[1]  Our goal is to invest in companies where the quality of the dividend is also high.

 

Evaluating High-Quality Dividends
 

All companies that pay dividends are not created equal. Those with a high dividend payout ratio, meaning they distribute a large portion of their cash flow as dividends, may struggle to maintain the dividend over a long period. Sustaining dividend payouts can be challenging for many reasons, including significant leverage, inadequate investment in the business, allocating a high percentage of free cash flow for dividends or stock repurchases and costly acquisitions—all of which can consume cash flow.

Another potential concern is companies that raise dividends to distract from deep problems in their operations. This can give the appearance of a steady dividend payer on the surface, but additional research may yield a different story.

As active managers, we often talk with companies to understand how they are deploying capital and their approach to paying dividends. Our evaluation focuses not only on the company’s fundamentals, but also the sustainability of its dividend. We aim to invest in dividend-paying companies that can maintain, and ideally increase, their dividends over time. We seek companies that are making decisions about how to spend their cash strategically, wisely and for the benefit of shareholders.

Our relative-value approach to selecting stocks focuses on out-of-favor companies that we believe are temporarily undervalued by the market. When we see stocks that are paying high dividends, we may screen them using four key attributes that help companies thrive in a growing economy and remain resilient during a downturn:

1. Increasingly relevant products or services
2. Durable competitive advantages that protect market share and profitability
3. Strong management teams that can act in the best interest of long-term shareholders
4. Sustainable business practices to support strategic and operational plans

 

A Dividend Case Study: Verizon and Pfizer

As of May 1, 2024, Parnassus Value Equity portfolio contains five stocks with dividend yields close to or above the 10-year Treasury rate: Verizon (VZ), Pfizer (PFE), Simon Property Group (SPG), Brookfield Renewable (BEPC) and Gilead (GILD).

_{Source: Factset. Data as of May 1, 2024.}

Our largest holding in the Value Equity portfolio is Verizon (VZ), the leading mobile network provider in the U.S. The company has gone through challenging times, underperforming the S&P 500 over the past several years as it took on debt to invest heavily in becoming a 5G network leader. While taking on debt can be a concern, we found it encouraging that Verizon was using it to strengthen its core business.

The company was also attractive, in our view, because concerns about debt left Verizon’s stock with a low valuation. Yet it has a dividend yield of around 7% as of May 1, 2024—the highest yield in the Dow Jones Industrial Average—as a result of the low stock price. Discerning the company’s underlying fundamentals helped to distinguish Verizon from other companies that have borrowed heavily to invest in costly Mergers & Acquisitions and eventually cut their dividend payments. We think Verizon’s free cash flow is poised to recover as it continues to generate high recurring revenue from its core business but spends less on capital projects in the coming years. We also consider a company’s credit rating to assess whether it is managing its borrowing responsibly. Verizon has maintained an investment grade rating with major rating agencies.

The stock price of another portfolio holding, Pfizer (PFE), slumped 44% last year as revenue from COVID-19 vaccines declined without a replacement due to few new therapies in its pipeline. We believe Pfizer has made a few strategic acquisitions that may strengthen its pipeline in ways that the market is underappreciating. Pfizer’s dividend yield is 5.7% and its bonds carry an A-bond rating by rating agencies, which we think signals confidence in its ability to maintain cash flows in the future. Pfizer has also been incrementally increasing its dividend, a sign of managerial confidence in its future performance.

 

Managing Risk in Pursuit of Resilience

We think of active management as another layer of risk management when we select stocks. Fixed income investors evaluate the coupon for the bonds they select. But they also think about the default risk in that coupon—whereas equity investors may not typically think about the default risk of the dividend. We think about the default risk of the dividend being cut or the equity depreciating dramatically. Our investment approach typically results in businesses that are poised to be resilient, and that’s especially important for a company paying dividends.

In some ways, dividends are appealing because of their simplicity: Owning the right stock can deliver you a regular paycheck every quarter in the form of dividends. Reinvesting dividends can help grow your investment, because more money is being put to work. But finding the companies with the best dividend policies requires careful research into their current and future prospects. Chasing high yields carries its share of risk but can be rewarding for companies that are mispriced or whose prospects are misunderstood. Accepting lower yields from companies that are positioned to keep raising dividends long into the future involves a careful evaluation that can pay off in the long run.

 

Glossary:

The Dow Jones Industrial Average (DJIA) is a stock market index that tracks 30 large, publicly-owned blue-chip companies trading on the New York Stock Exchange (NYSE) and Nasdaq.

Dividend yield is the annual dividend per share divided by the stock price per share. Past performance cannot predict future results. Dividends are not guaranteed and may fluctuate.