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

It's a good problem to have when you have enough money available at the end of the month to choose how to use it. Should you invest for the future? Or get a little to spend on something now? In the best case scenario, you can do both.

Generating abundant cash flows is one of the signals of a quality company. But how the company decides what to do with that money can also provide 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, buy back outstanding shares to help increase the share 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 a strong dividend, it is less likely to waste excess cash on potentially fruitless investments in the business.

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

Valuation of high quality dividends

All dividend paying companies 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 the long term. Maintaining dividend payments can be challenging for many reasons, including significant leverage, insufficient investment in the business, allocating a high percentage of free cash flow to dividends or share repurchases, and costly acquisitions—all of which can consume cash flow.

Another potential concern is companies that collect dividends to distract from deeper problems in their operations. This may give the appearance of a consistent dividend payer on the surface, but additional research may tell a different story.

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

Our relative value approach to stock selection focuses on disadvantaged companies that we believe are temporarily undervalued by the market. When we see stocks that pay high dividends, we can 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. Sustainable 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's stock portfolio contains five stocks with dividend yields near 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 US. The company has had a challenging time, underperforming the S&P 500 over the past few years, while it took on debt to invest heavily to become 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 debt concerns left Verizon stock undervalued. However, it has a dividend yield of about 7% as of May 1, 2024 — the highest yield in the Dow Jones Industrial Average — as a result of its low share price. Uncovering the company's fundamentals helped distinguish Verizon from other companies that have borrowed heavily to invest in costly mergers and acquisitions and ultimately cut their dividend payouts. 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 share price of another portfolio company, Pfizer ( PFE ), fell 44% last year as revenue from COVID-19 vaccines declined beyond replacement due to several new therapies in the pipeline. We believe Pfizer has made some strategic acquisitions that could strengthen its pipeline in ways that the market is underestimating. Pfizer's dividend yield is 5.7% and its bonds carry an A-bond rating from the rating agencies, which we think signals confidence in its ability to maintain future cash flows. Pfizer has also gradually increased its dividend, a sign of management's confidence in its future performance.

Risk management in pursuit of sustainability

We think of active management as another layer of risk management when picking stocks. Fixed income investors rate the coupon on the bonds they choose. But they also think about default risk on that coupon—whereas equity investors can't usually think about dividend default risk. We think about the risk of not paying the dividend cut or dramatic capital depreciation. Our investment approach usually results in businesses that are willing to be resilient and this is particularly important for a dividend paying company.

In some ways, dividends are attractive because of their simplicity: Owning the right stocks can give 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 companies with the best dividend policies requires careful research into their current and future prospects. Chasing high yields carries its share of risk, but it can be rewarding for companies that are mispriced or whose prospects are misunderstood. Accepting lower yields from companies that are positioned to continue growing dividends long into the future involves careful valuation that could pay off in the long run.

Glossary:

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

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