Next time you’re ready to go shopping for dividend-paying stocks, consider taking a detour from the heavily trafficked utility and real-estate sections and head for the technology aisle.
While hot new social media stocks and their gravity-defying valuations tend to grab headlines, it’s the tech sector’s emergence as a dominant dividend payer that deserves your attention.
Tech companies account for nearly 15% of total dividend payouts for the S&P 500® Index. That’s not only the single largest sector contribution among the 10 broad sectors, it’s triple what tech stocks delivered a decade ago, according to S&P Dow Jones Indices.
Unfortunately, if you’re invested in mutual funds and exchange-traded funds (ETFs) that are focused on dividends, you could be too light on tech stocks—and that’s something you may want to remedy.
After all, a growing number of tech companies are paying dividends, including Apple, Cisco Systems and EMC. And tech’s dividend payers are generating so much free cash flow that the sector’s average annualized dividend-growth rate was almost 30% for the past five years, according to S&P Dow Jones Indices. That's nearly four times the overall pace for the S&P 500.
Do a tech check of your dividend ETFs
Yet most indexes—and plenty of active managers—will scarcely acknowledge a dividend stock until it has been making and consistently growing payouts for at least 10 years. For example, the $13 billion SPDR® S&P® Dividend ETF focuses on stocks in the S&P Composite 1500® Index that have increased their dividend payouts for 20 consecutive years.
Thus, not only are tech’s dividend-paying newbies ineligible for the ETF, so too are the likes of Microsoft and Qualcomm, which have been paying dividends for more than 10 years but fewer than 20 years. In fact, less than 5% of the SPDR S&P Dividend ETF is invested in the tech sector, despite tech stocks accounting for nearly 20% of the S&P 1500.
Granted, a long history of consistently growing payouts is desirable. But Brad Sorensen, director of market and sector analysis at the Schwab Center for Financial Research, says the shorter dividend history within some companies is not cause for concern. “No company wants to stop paying, and the large cash balances and low debt levels for many tech companies make it unlikely they would reduce their payouts,” he says.
Tech dividends have room to grow
In fact, tech stocks have plenty of room to keep the strong dividend growth coming. The best indicator for determining a company’s capacity to increase its dividend is its payout ratio. You can gauge a stock’s payout ratio fairly easily on Morningstar, by calling up the quote and clicking on Key Ratios (under the company name and ticker symbol). This metric tells you the portion of a company’s earnings that management pays out in dividends.
Among technology dividend stocks in the S&P 500, the average payout ratio is 30% these days. Brad notes that while there is no hard and fast rule on what constitutes a “good” payout ratio, anything below 50% means a company has plenty of flexibility to keep increasing its dividend at a healthy pace. By comparison, the utility sector has an average payout ratio of 75%.
Now for an important caveat: Brad cautions that while the tech sector has the capacity to keep generating strong dividend growth over the long term, it may not come in a steady, annual stair-step climb, given that the sector is more cyclical than, say, utilities or consumer staples. “Dividend growth in tech stocks will not be as cut-and-dried,” he says. “There could be a year where you don’t get any growth.”
Indeed, there is the possibility of short-term dividend reductions or even cuts—which did occur with some stocks during the economic crisis of 2008–09.
The potential for capital appreciation
For patient investors, there’s room for above-average dividend growth and capital appreciation in the stock price. True, tech stocks can be among the most volatile. But Brad notes that the never-ending quest by businesses to boost their productivity—coupled with nascent signs that companies are finally loosening their purse strings to upgrade their systems for the first time since the financial crisis—should create more demand for technology.
Certainly, even after considering the risk, the potential for gain on two fronts could persuade savvy dividend seekers to start browsing in the technology aisle.