The investment market has been rocky the past few years, and there is no indication that volatility is going to change any time soon.
But current market conditions make it an excellent time to invest in dividend-paying stocks, says Sonia Mintun, CFA, vice president with Ancora Advisors LLC.
“Given the historically low bond yield environment, dividend-paying stocks are an attractive alternative,” says Mintun. “Right now, you can assemble a portfolio of quality stocks with a yield of 3 to 3.5 percent, in comparison to the 10-year Treasury yield of approximately 2 percent. Dividend-paying stocks also offer downside protection, providing a cushion during negative equity markets, while also allowing for the capture of upside potential.”
Smart Business spoke with Mintun about why dividend-paying stocks are a smart investment in today’s economy.
Why does dividend-oriented investing make sense in today’s markets?
There are several reasons: Dividend-paying stocks are less volatile than non-payers and they have been proven to have a lower standard deviation, which is a measure of risk. Dividends have accounted for 40 percent of total returns in the market since 1940, and dividend-paying stocks have outperformed non-dividend-paying stocks over the last 80 years. These stocks tend to be relatively stable over time because dividends are a component of earnings that are less subject to speculation. In addition, dividends are sticky, and tend not to fall, as companies are reluctant to cut them. Dividends allow investors to collect some income while they’re waiting for the fundamentals of the company to improve.
Furthermore, payout ratios are hovering at extremely low levels historically. They tend to revert to the mean over periods of two to three years. The current payout ratio is 30 percent, compared to a historical rate of 52 percent. With increased confidence and economic stabilization, we will likely see deployment of large cash balances on companies’ balance sheets toward higher payouts.
Dividend yields are also below long-term averages of 2.8 percent. Currently, yields are about 2 percent, despite cash balances being at record highs. Moreover, earnings are recovering from the financial crisis and balance sheets are healthy, so there is good potential over the next year or two that yields will rise due to increased payout ratios.
Last, given today’s bond yields, the S&P earnings yield — which is the inverse of the price/earnings ratio — is pretty attractive relative to the 10-year Treasury on a historical basis.
How does inflation impact dividend-paying stocks?
Historically, dividends have grown faster than the rate of inflation in the U.S. With 3 percent inflation now, short-term, high-quality, fixed-income instruments are losing purchasing power. You can get a 3 or 3.5 percent dividend yield on a diversified portfolio of good quality stocks, and have potential for income growth relative to the fixed coupon on bonds.
The average dividend income from a portfolio of S&P indexed stocks has grown at a rate of 5 percent per year since inception in 1957, which is one full percentage point over the rate of inflation in the same time period. As a result, dividend stocks offer both the potential for capital appreciation and income growth. Dividends increased more than 10 percent in 2011, on top of a 10 percent gain in 2010. Also, dividend-paying stocks have outperformed more often in higher inflationary times.
What vehicles can be used to implement a dividend-paying strategy?
Investors can buy individual equities in portfolios that are sizable enough to diversify the risk of one particular issue or sector. While dividend-paying stocks tend to be less volatile, it’s prudent to make sure your portfolio is not too concentrated in one sector or company.
Investors can also buy exchange traded funds, or ETFs, that concentrate on dividend-paying stocks. ETFs are a cost-effective way to invest in dividend payers while achieving diversification in smaller accounts. There are also mutual funds that focus on dividend-paying companies. These typically have higher expense ratios than exchange traded funds, but the fund manager can trade them more tactically than ETFs, which are passively managed and based on an index.
Are all dividend-paying stocks the same?
All dividend-paying stocks are not the same. It’s very important to do your homework on the company when you are buying individual stocks. Higher yield stocks are associated with better subsequent performance, but only to a degree. Those in the 3 to 6 percent dividend yield bucket have outperformed their peers, both those with higher dividend yields and those with lower yields.
Stocks with yields in the 6 to 9 percent range and above tend to have a higher standard deviation, or risk. Sometimes investors fall into the yield trap, buying troubled companies that cannot sustain high payouts, leading to cuts in their dividends.
Investors should seek stocks in which the dividend can be sustained, potentially evidenced by a low payout ratio and ample net cash or share buybacks. Look for companies that have consistent cash flow, a healthy balance sheet for their industry and that increase their dividends consistently.
Given today’s historically low bond yields, the potential for inflation down the road, as well as the other reasons I detailed, investing in dividend-paying stocks makes sense. With the expectation that volatility is going to continue due to our upcoming election and events in Europe, investing in less volatile stocks paying dividends is a sound strategy. Furthermore, based on price/earnings ratios and the potential for improving earnings, the disparity between the earnings yield on the S&P relative to 10-year Treasury bonds make dividend stocks an attractive investment.
