Dividend Stocks - What's All the Hype About?

In an effort to help the U.S. economy recover, the Federal Reserve has lowered interest rates to historically low levels. Furthermore, the Fed has announced its intent to keep interest rates low until 2014. Classic income-producing investments such as savings accounts, certificates of deposit, and money market funds pay next to nothing. Borrowers are being rewarded but savers are being punished.

Low interest rates may have spurred the economy somewhat, but they have been devastating for retired people who have a low tolerance for risk. Investors and their advisors are turning toward alternatives that pay higher returns, but these vehicles necessarily carry higher risk. Among these alternatives, some investors are considering the purchase of stocks that pay reliable dividends.

Critics of dividend-paying stocks argue that companies paying dividends are weak because they should be investing their cash back into the company to foster growth. These critics would clearly be in the growth stock camp, where capital gains are expected to provide the bulk of investment returns. Proponents of dividend-paying stocks feel that companies sharing their profits with shareholders reward investors and capture their loyalty.

How important have dividends been over long periods of time? One study examined the components of total equity returns of U.S. stocks from 1802 to 2002. Over this 200-year period, dividends accounted for 5.8% of the 7.9% of total annualized returns.¹ Another study of global stocks from 1900 to 2005 found that the real return across seventeen countries averaged about 5%, while the average dividend yield was 4.5%.² In other words, dividends provided 90% of the return.

Studies also show that dividend-paying stocks hold up much better than their non-dividend paying counterparts during bear markets. The two above research papers, as well as many others, support the tenet that dividend-paying stocks have provided higher cumulative returns with lower levels of volatility than non-dividend paying stocks.

It is important that investors don’t fall into the trap of buying stocks merely because they have high dividend yields. The unwary investor could purchase financially unstable companies such as banks that hold debt with questionable value. Other companies may temporarily pay a high dividend to maintain a positive image with its shareholders, even though current and future earnings will not support the dividend payments. To minimize risk, investors must consider the financial strength of companies through an in-depth screening process.

In response to client requests, one of Net Worth Advisory Group’s recent research projects created a portfolio of dividend-paying stocks in large, financially-stable companies that have relatively high dividend yields. Two portfolios of dividend-paying stocks were used as a basis for our research: 1), The SPDR Standard & Poors Dividend exchange traded fund (SDY); and 2), the Dividend Yield Folio at Folio Investments.

The SPDR S&P Dividend exchange-traded fund (ETF) consists of 60 stocks and seeks to closely match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. Folio Investments created the Dividend Yield Folio by choosing the largest 100 companies with the highest overall dividend, adjusted for market capitalization, utilizing the principles of fundamental investment analysis.

Of the 160 total stocks analyzed, 80 passed our rigorous filtering process. As a consequence, we appropriately named the group of 80 companies the “Dividend 80” portfolio. To create our model, we allocated funds evenly among the eighty stocks -- thus each stock represents 1.25% of the portfolio. Statistics over the last ten years produced results that supported the independent research we have cited in this article.

A Morningstar Principia® portfolio snapshot shows that the Dividend 80 portfolio would have significantly out-performed the S&P 500 over the last one-year, three-year, five-year, and ten-year periods. During the last ten years, the S&P 500 experienced its largest twelve-month loss of -44.85% between March 1, 2008 and February 28, 2009. The Dividend 80 portfolio would have lost -33.26% in the same twelve-month period.

Another test shows that during a shorter, five-year period from 2/21/2007 through 2/17/2012, the Dividend 80 portfolio would have produced a total return of 27.80%. During this same period, the S&P 500 Index including dividends had a total return of 4.05%, and the SPDR S&P Dividend exchange-traded fund had a return of 7.41%.

We are concerned when any investment method becomes too popular. If investors were to pile into dividend-paying stocks, their prices would increase and yields would decline. We don’t believe the market is close to that point yet, but the possibility of such a trend deserves our vigilance.

Whereas dividend-paying stocks don’t offer the security of savings accounts or CDs, they have an important role to play as one of the sectors in a well-allocated investment portfolio. Investing in dividend stocks is accompanied by higher market risk, but investors with a twenty to thirty-year investment horizon should be willing to accept some market risk in order to combat inflation.

Please let me know if you are interested in learning more about the “Dividend 80” folio.

Footnotes:

1. Robert D. Arnott, “Dividends and the Three Dwarfs.” Editor’s Corner, Financial Analysis Journal, 2003.

2. “The Worldwide Equity Premium: A Smaller Puzzle” by Elroy Dimson, Paul March and Mike Staunton, 2006.

Past performance is not a guarantee of future returns. Dividend yields can change over time. Dividend paying stocks are subject to fluctuations in market value. The Dividend 80 Portfolio is only available only on the custodial platform at Folio Investments.