From the August 2013 issue of Research Magazine • Subscribe!

Dividend-Paying Stocks: Compelling Characteristics

Regardless of conditions in the stock and bond markets, dividend-paying stocks have plenty to offer investors — especially retirees, experts say

Dividend-paying stocks have attracted lots of investor and advisor attention, especially when—for much of the second half of 2012 and the first quarter of 2013—fixed-income rates were at historic lows. For investors and their advisors, this situation meant that the stocks’ attractive yields were seen as the best-available income option.

Plus, dividends can cushion investors against market volatility. This was important over the past year or so, when the Dow Jones Utility Index (DJU), a rate-sensitive index, moved from 438.05 on November 15, 2012, to a peak of 537.32 on April 30, 2013.

Positive Outlook

Several factors bode well for such stocks going forward, despite the recent shift in interest-rate dynamics, experts say. First, dividend payouts have been growing and look likely to continue growing, says Mike Boyle, CFA, senior vice president of asset management with Advisors Asset Management in Lisle, Ill., who tracks roughly 40 years of dividend data.

Citing the most recent figures, Boyle reports that dividends paid in June 2013 were 23% higher than those paid in June 2012, an increase he describes as “phenomenal.”

That result isn’t a one-month aberration. When Boyle compared the most recent trailing 12-month period to the previous 12-month period, dividends paid were 17.5% higher, roughly triple the historical long-term average increase of 5.93% for comparable periods.

“Dividend growth right now is as robust as it’s ever been or at least over the 40 years that I’ve been tracking it,” he says. Fortunately, the good news doesn’t stop there.

Dividend payout ratios are hovering around 30% versus a historical value closer to 40%, Boyle notes. If companies bring payout percentages back to their average that will translate to roughly a one-third overall increase in dividends paid.

Their cash flow situations are “very, very strong,” he says. “I can find something yielding 2, 3 [or] 4% and growing that yield 10, 15 [or] 20%.” Such results can prove very attractive to many segments of investors, including retirees.

Retirement  Rush

The Baby Boomers’ impact on the demand for financial assets has been debated for years, experts say. One widespread forecast in the late 1990s was that Boomers would invest in stocks while they were working and then reallocate their portfolios to bonds at retirement to reduce volatility.

That scenario made sense for a time, recalls Josh Peters, CFA, a Chicago-based equities strategist and editor of the Morningstar “DividendInvestor” newsletter. “You had a couple of years when the market went up 25% a year like clockwork, and the idea was, you ride this wave until you retire,” he says. “Your portfolio just swells with all these capital gains, and then you sell all the stocks and you buy bonds. Back then a 10-year Treasury yielded 6 or 7%, and you could actually see how something like that could work.”

Unfortunately, investors experienced two stock market crashes, and the broad indexes haven’t even kept pace with inflation, Peters notes. Interest rates have fallen significantly, so the notion of cashing in flush stock portfolios for juicy bond yields got squashed from both ends. 

Consequently, the Boomers’ need retirement for income could spur strong demand for dividend-paying stocks in their post-retirement periods.  Unless we experience the unlikely combination of low inflation coupled with higher interest rates, Peters believes that retirees will continue to rely heavily on quality stocks to help generate the income and total returns needed to fund their retirement strategies.

“Dividend yields are going to become much more important, much more sought after, and risk tolerance is going to go down,” he explains. “People are really going to want those nice steady stable companies that spin off big dividends and keep raising them every year.”

Growth Stories

Unlike bonds, dividend stocks can increase their distributions and potentially generate significant capital gains via price appreciation. “Bonds don’t grow their coupon,” says Henry Sanders III, CFA, executive vice-president and senior portfolio manager with River Road Asset Management in Louisville, Ky.

“They don’t pay you more interest every year. The dividend will do that. You’re not just earning a dividend stream, you’re earning a growing dividend stream,” Sanders explains.

“There’s a company that’s growing their business, and they’re growing their revenues. That helps lift the stock, because when interest rates start going back up that means the economy is getting stronger, companies have more pricing power, [and] their earnings should increase,” he notes. “That offsets the impact of interest rates moving up.”

Ryan Issakainen, senior vice-president, exchange traded fund strategist for First Trust Advisors, LP in Wheaton, Ill., agrees that broad comments about dividend stocks don’t tell the full story, since all dividend-paying stocks do not have the same risk and return characteristics. The growth of a stock’s dividend is an important differentiator, Issakainen argues.

Dividends, Discipline

In addition, dividends provide information about a company’s finances and its managers’ business outlook. Sanders cites an example of a company that announces a substantial dividend increase.

“Management can throw out projections, here’s what we expect things to be,” he says. “It’s worth what it’s worth, not usually a whole lot. But, when they say, we’re raising our dividend 20%, you’re talking about cash. They’re paying out 20% more cash. You can do things to massage earnings, make revenues look better and make earnings look better. But you can’t fake cash, right?”

Freezing, cutting or suspending a dividend also conveys information. When a company makes one of these changes to its policy, that’s a signal, says Sanders, and probably not a good one. The company’s business may be generating less free cash flow than anticipated, it may be carrying too much debt, and so on. These changes are signals to investigate the company’s finances and outlook further.

Enduring Advantages

Even if rates should continue to move higher, that doesn’t change the long-term case for dividend stocks, experts point out. Mark DeVaul, CFA, CPA, portfolio manager with the London Company in Richmond, Va., notes that dividends have provided about half of stocks’ total returns since the 1930s.

Returns on dividend-paying stocks can be less volatile than non-dividend payers, DeVaul adds, and they also help protect purchasing power.

They “give you that hedge against inflation,” he says. “We don’t know what’s going to happen long term with interest rates or the inflationary environment, but dividends can definitely provide you a nice offset there.”

Peters believes that from an investor’s perspective, it’s irrelevant whether or not dividend-paying stocks are “the flavor of the month on Wall Street.”  What makes dividends attractive, he argues, is that they work very well for shareholders, because they provide an opportunity to “put my money to work in companies that are very high quality, financially strong, competitively advantaged and making that commitment to reward shareholders directly.”

Dividends also increase shareholders’ flexibility in managing their portfolios, Peters says. Retirees can take the distributions for income while younger investors can reinvest their dividends in the issuing company or invest them elsewhere. “Those are huge advantages that get right down to the kind of reasons people want to invest in the stock market in the first place, at least for the long term,” he says.

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