Dividends have accounted for 40 percent of total returns in the market since 1940. Some investors are concerned about recent stock price increases, but there still is room to invest in dividend-paying stocks, especially for the long term, says Sonia Mintun, vice president and portfolio manager at Ancora Advisors LLC.

“For the long term and at current valuations, particularly given historically low payout ratios, dividend-paying stocks can see strong relative and absolute performance. The outlook is enhanced by near all-time low U.S. Treasury yields and the Federal Reserve’s extended dovish position on interest rates,” she says.

Although the upcoming election and global economic environment are areas for concern, Mintun says an emphasis on high-quality dividend-paying stocks at low valuations should cushion investors from volatility and provide real returns over the long term.

Smart Business spoke with Mintun about the current stock market and how dividend-paying stocks remain a smart investment.

With the recent run-up in equities, is the dividend-paying strategy overvalued or a crowded trade?

Over the last year or more, the dividend theme has been the popular trade and the market has run up. There are a number of ways to evaluate if the market — and therefore dividend-paying stocks — is overvalued. You can examine whether it is trading at lower-than-average yields, or higher-than-average valuation ratios such as price-to-earnings (P/E), price-to-book (P/B) or price-to-cash flow.

The current market’s value is dependent on an investor’s time frame and risk tolerance. Is it overvalued for the next several months? It is possible we could see some pullback, but looking over the long term, it is our view that dividend stocks are not overvalued. The trailing P/E ratio of the S&P 500 index is around 14, which is lower than its historical norm and nowhere near where it was during the tech bubble when P/E ratios were closer to 50. While you can argue that the economic growth outlook is sluggish, companies have become operationally leaner, which has helped boost profit margins. They have better positioned their balance sheets by refinancing debt at extraordinarily low interest rates and have historically high cash levels. Lastly, with regard to dividend payers in particular, yields are at close to seven-year highs, while payout ratios are low, suggesting current yields are well supported by earnings. So overall, our opinion is that dividend-paying stocks remain attractive for long-term investors, especially in comparison to fixed-income yields.

What sectors have performed better and may be perceived as overvalued?

Defensive sectors such as consumer staples, health care and utilities have attracted a lot of capital and could be perceived as overvalued. Their P/E multiples compared to the overall market are trading at premiums to their five-year averages, but it is not a significant premium. Utilities, for example, are the most correlated sector, with 10-year treasury yields that have an 80 percent correlation since 1990. If you think that rates are going to stay low for some period, utilities may not be overvalued based upon the five-year averages.

What dividend-paying sectors have underperformed?

Economically sensitive stocks, such as energy, industrials and materials, have fared the worst, largely due to fears about slower growth in emerging markets and from concerns in Europe. However, many stocks in these sectors are trading at attractive discounts to their historical valuation ratios. They have ample cash on their books, generate consistent cash flows and could see improving profitability with higher commodity prices and demand if global stimulus takes hold.

What impact will the potential tax changes have on dividend-paying stocks?

A potential dividend tax increase has concerned some investors about owning dividend-yielding stocks. In 2001 and 2003, dividend tax cuts were put into place that reduced the dividend tax rate to 15 percent from 35 percent. These cuts are set to expire at the end of this year unless Congress extends them or passes new legislation. If no legislation is passed, taxes return to a top marginal rate of 39.6 percent. This tax increase may be a short-term negative for stocks and high-yielding stocks.

However, history has shown that tax increases do not have a long-term negative effect on dividend-paying stocks, as stocks typically recover after six months or so following an increase. This may be because an estimated 50 percent of equity held is owned by tax-exempt entities — such as qualified plans, foundations and foreign investors — all of which are somewhat indifferent on taxes. In addition, when tax increases are anticipated, it has typically not been problematic over the long term. For example, beginning in 2013, a new Medicare contribution tax of 3.5 percent will be imposed on investment income. This proposed tax increase has had minimal effect on the stock market so far.

What is the long-term outlook for dividend-paying stocks?

Longer-term dividend-paying stocks remain an attractive option for risk-averse, equity-oriented investors. Dividends provide a cushion during poor equity markets and are relatively stable over time. Consequently, by being less volatile and being more disciplined with capital because of the dividend policy, dividend-paying companies have outperformed non-dividend-paying companies for more than 80 years. Additionally, with dividend payout ratios near historical lows and weighty cash balances, companies may return more cash to shareholders in a low-growth environment. Given today’s low interest rates and continued global economic turbulence, we see dividend paying stocks as attractive now and for the long term.

Sonia Mintun is a vice president as well as an Investment Advisor Representative of Ancora Advisors LLC (an SEC Registered Investment Advisor). In addition, she is also a Registered Representative of Ancora Securities, Inc. (Member FINRA/SIPC).  Reach her at (216) 593-5066 or sonia@ancora.net.

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