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A Slow And Steady 6% Dividend Yield Can Win Lots Of Races

Dividend growth is the go-to strategy when rates are expected to rise.

Companies with dividends that are unsustainably high risk having to cut their dividends which leads to selling and price declines.

Some companies pay higher than average dividends with reasonable payout ratios that limit the downside risk of dividend cuts.

Some of these companies are poised to see modest investor interest as the search for yield continues, which could cause the price to increase.

Markets have been very volatile in 2015, particularly compared to the previous three years. For some investors, myself included, this causes anxiety that frankly I would prefer to do without. So, I have begun looking for positions to add to my portfolio that would provide a modest level of growth, but at the same time will do so with very little volatility from quarter to quarter.

These types of investments usually fall into the category of safe dividend paying variety because companies that pay dividends tend to have less volatility and companies with stable businesses tend to have the capacity to pay consistent dividends.

In this environment of rising rate expectations however, the more favored dividend strategy is to invest in companies with the potential to increase their dividend, not necessarily those companies with the highest dividend. The dividend growth strategy makes sense in a rising rate environment because it could be viewed like a floating rate bond, where the dividend payout increases along with rates, just like a floating rate bond would increase its coupon as rates rise.

On the contrary, a stable dividend not expected to grow is more comparable to a fixed rate bond and tends to decline in price as rates rise, just like fixed rate bonds. Stocks particularly at risk are those whose dividend is not high enough to compare favorably to other high yielding securities (either fixed income or equities), and those whose dividend is unsustainably high as evidenced by a high payout ratio.

A happy compromise is to find a company with an above average dividend yield, modest dividend payout ratio, and low to moderate dividend growth. One such company is AT&T (NYSE:T).

AT&T

AT&T has had rock steady revenues each quarter as can be seen from the green line in the chart below. To put the stability of quarter to quarter revenues for AT&T in perspective, I also included the same data for Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT).

The differences in quarter to quarter revenue changes are profound but logical. Apple relies on new product launches every 12-15 months and the revenue pops are evidence of this. Microsoft has more steady revenue on a quarter to quarter basis than Apple but AT&T consistency over the last 10 quarters is quite impressive. The green line in the chart is practically horizontal with a slight upward slope.

For each of the companies mentioned, I also calculated the standard deviation of revenues as a percent of the average quarterly revenues to compare the volatility on a relative basis and the results are shown below. The data confirms what the chart already revealed. AT&T has a quarterly revenue standard deviation of just $896 million and an average of $32 billion. That is just 2.8% compared to Apple at 38%.

Source: Morningstar

The price to sales multiples are reasonably aligned with the growth prospects of each company, give or take the slight over/under valuations given to each by Mr. Market. Apple is a high growth company and has a much higher price/sales multiple than slower growing AT&T both at current levels and for the long-term average. But both seem to be slightly undervalued relative to their respective long-term average multiples and I might add, the catalyst for multiple expansion is completely different for both.

For Apple, continued price appreciation will come from meeting or exceeding new product unit sales every time a new product is launched, and in the not so distant future, it will be the iPhone 6S and 6Plus launches that will drive its stock price up or down depending on sales results. For AT&T, what may drive the multiple higher is continued investor interest in stable companies that pay decent dividends.

Forecasted Performance and Steady Dividends

According to the consensus analyst estimates for 2016 earnings per share, AT&T should earn $2.79 per share next year. At an average 10-year PE multiple of 13.5, the estimated price at the end of 2016 is $37.66, for a 17% gain.

It doesn't seem too unreasonable considering the earnings estimate is just 5% above the 2015 estimate of $2.65, and the current multiple is 12.3.

Add in an estimated dividend of $2.44 (6% yield) per share and the potential return of AT&T stock is approximately 24.5% through 12/2016, which is a 19% annualized return. Not too shabby for a slow growth company!

So while analysts are tooting the horn of fast dividend growth companies in a rising rate environment, don't completely ignore the slow but steady growth characteristics of a company whose revenues are boringly predictable and paying a 6% dividend.


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