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Philip van Doorn

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April 2, 2015, 12:57 p.m. EDT

For dividend stocks, look to tech for big gains

The industry throws off a lot of cash, which feeds dividend increases and share-price outperformance

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By Philip van Doorn, MarketWatch

Bloomberg News/Landov
Apple pays an annual dividend of $1.88 a share for a yield of 1.49%, but its free cash flow yield of 6.63% shows the company is throwing off plenty of excess money that could support a much higher payout.

Do you think dividend stocks are boring? If yes, is it because your goal is share-price growth, not current income?

You might want to think again. As we’ve discussed in our reviews of the S&P 500 Dividend Aristocrats, this group of 52 stocks that are included in the S&P 500 Index /zigman2/quotes/210599714/realtime SPX -0.94%  and have also raised their dividend payouts for at least 25 straight years has outperformed the broader market.

The S&P 500 Dividend Aristocrats Index has greatly outperformed the S&P 500 Index.

Over the past five years, the total return of the S&P 500 Dividend Aristocrats, with dividends reinvested, was 115% through Friday, and its 10-year total return was 179%. In contrast, the S&P 500 Index’s returns were 94% and 120%, respectively.

So even if you don’t need the income and will reinvest the dividends, the Dividend Aristocrats might be a better vehicle for long-term growth. A vehicle for that strategy is the ProShares S&P 500 Dividend Aristocrats ETF /zigman2/quotes/208747379/composite NOBL -0.35% .

Bill McMahon, chief investment officer at ThomasPartners, which has $6.8 billion in assets under management, focuses on companies that pay dividends and generate sufficient free cash flow to provide plenty of “headroom” for dividend increases. That opens up many more possibilities, because there is no limit based on previous dividend payouts, as there is for the S&P 500 Dividend Aristocrats.

Free cash flow is a company’s remaining cash flow after capital expenditures. It represents the cash that the company’s board of directors might deploy through acquisitions, stock buybacks or dividend payouts.

When following this strategy, McMahon pointed out in an interview on Monday, be aware that dividend stocks don’t necessarily need to offer high yields. What’s important is knowing which companies pay dividends and have the capacity to increase them significantly.

McMahon is enthusiastic about the technology sector because it has a solid free cash flow margin of 21.3%, along with an average free cash flow yield of 6%, which he said is significantly higher than the average of 3.6%.

The free cash flow margin is calculated by dividing free cash flow by sales, while the free cash flow yield is free cash flow divided by the share price.

According to McMahon, “the crux of the bull/bear debate for tech stocks is whether or not this high profitability will continue.” He believes it will, as companies refrain from spending for several reasons.

First, with memories of the 2008 and 2009 crash still fresh, tech companies are trying “not to overbuild or grow too much capacity,” he said.

McMahon added that improved technology is “contributing to a very real increase” in productivity and profitability. He also sees the “outsourcing of supply chains” to Asia as providing a continual boost to tech companies’ profitability.

So McMahon’s strategy can be somewhat counter-intuitive, because he would rather see a company build free cash flow than plow a significant amount of cash back into its business.

We calculated free cash flow yields for technology stocks included in the Nasdaq Composite Index, as well as the few in the S&P 1500 Composite Index that aren’t also listed on the Nasdaq.

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