Investing in companies that sell the behind-the-scenes machines of the U.S. economy, such as elevators and turbines, is the best way for dividend-hungry investors to sate their appetite.
The industrials sector of the stock market has added more dividend-paying companies in the past 11 years than any other sector, including dividend stalwarts energy and health care, according to FactSet Dividend Quarterly. In the last quarter of 2013 alone, 45 industrial companies raised their dividends.
There's a straightforward reason: Dividends in the industrial sector rise alongside U.S. industrial production. Industrial production remains below its long-term rate (1972–2013), but it has increased year over year, according to Federal Reserve data. Factory production showed its biggest gain in four years this past February, and in March, manufacturing capacity hit its highest level since June 2008, Fed data shows.
"Favor companies that will benefit from the North American manufacturing renaissance," said Brian Belski, chief investment strategist at BMO Capital Markets.
Big, diversified industrial conglomerates have strong balance sheets and lots of cash to keep pumping out payments to investors during tough economic times, and now "industrials are fertile ground for rising dividends," said Don Taylor, portfolio manager of the Franklin Rising Dividends Fund, which has more than $15 billion in assets. "After the financial crisis, the companies have a lot of financial flexibility."
Discovering the dividend sweet spot
Taylor has managed the fund for 18 years and has developed some rules for finding the dividend sweet spot among the dividend-rich industrial sector.
Taylor's fund is currently overweighted in industrial stocks, including diversified conglomerates. He looks for companies with consistent dividend growth—increases in 8 out of 10 years. He also looks for companies with steady growth prospects and avoids companies with boom-and-bust cycles. "They don't work for me," he said, "since they may pay one-time dividends and then it's over."
United Technologies, which yields 2.1 percent and has raised its dividend for many years, is an example of a large holding within Taylor's fund. The diversified company increased its dividend 10 percent last year. "And the company has a tailwind of growth," Taylor said. He also has made investments in Dover and Roper Industries, which has only a 0.60 percent dividend but has very high dividend growth prospects, Taylor said.
Experts caution that leaping for high yields with poor-performing stocks is a big mistake. Take storage and information-management company Iron Mountain, whose shares are down 25 percent in the past year. Iron Mountain offers a dividend yield of roughly 4 percent. ADT, a security firm that makes alarms, has dropped by 34 percent in the past year, though it yields 2.75 percent.
In fact, "stocks may be high yielding because they've dropped a lot," Taylor said. "But the yield doesn't tell you anything about the company's value. Look very carefully."
A good way to gauge dividend-paying ability is to look at free cash flow, according to Bill McMahon, chief investment officer at ThomasPartners, a subsidiary of Charles Schwab that focuses exclusively on finding the market's best dividend-growth opportunities. Free cash flow is operating cash flow minus capital expenditures, and dividends come out of this pool of money. "The flow must be sustainable," McMahon said. Industrials have done a "tremendous job of cutting costs," he added, "so they have high operating margins."
McMahon has a preference for slow-growth companies with reliable dividend growth. One example comes from within the defense niche of industrial stocks, where dividends have steadily grown over time. Lockheed Martin, which yields 3.3 percent, has a five-year annual compounded dividend-growth rate of 21.9 percent, compared to only 4.2 percent for the S&P 500, according to Factset. Raytheon, which yields 2.5 percent, has a 10-year dividend-growth rate of 10.6 percent, compared to 6.1 percent for the S&P.
Looking for dividend yields that are above the S&P average—currently 1.96 percent—is a good first step in the search for reliable dividend streams, said Josh Peters, editor of the Morningstar "DividendInvestor." But Peters cautioned, "Yield alone isn't sufficient." A focus on total return, which is dividend income plus stock growth, is the investor's best bet.
It is also wise to diversity dividend streams from within a stock portfolio across sectors. "You don't want just utility or consumer staples dividend stocks in your portfolio," Peters said. "Industrials are good diversifiers."
Peters provided Emerson Electric, which yields 2.6 percent, as an example. The company has 50 years of uninterrupted dividend growth and more than $3 billion in cash on the books. In good years the dividend rises 10 percent to 15 percent. In weak years the dividend increase may be only 2 percent. It's long-term, reliable dividend growth that matters most, Peters said, and dividend variability should not be a concern. Dividend cuts that are linked to highly cyclical companies, including in the mining and construction niches, are something to avoid. "You have to put your paranoid hat on," Peters said.
Belski pointed to General Electric and Waste Management among his favorites. Both stocks yield roughly 3.5 percent. GE has a highly diversified business and more than $88.5 billion in cash, as well as a hefty 19.8 percent three-year compounded annual dividend-growth rate, according to FactSet.
"Industrial stocks are usually misunderstood," McMahon said. "Most people assume that they're highly cyclical. But industrials is one of our favorite groups."