The case for including dividend stocks in client portfolios remains strong. Many of the advantages were shared in a Fidelity Investments research report, “Equity Total Return: Lower Volatility in the Longer Term.”

Dividend-paying equities have been able to offer better inflation protection than bonds. Inflation hasn’t been a concern recently, but price increases are likely to accelerate at some point as the economy recovers. When that happens, fixed-payment bonds lose purchasing power.

In contrast, shareholders have more of a buffer, Fidelity notes: “Broad-based price increases throughout the economy may lead to higher corporate revenues, allowing profits—and potentially stock prices—to increase on a nominal basis and offset rising inflation rates.”

Dividend-paying equities have tended to be less volatile. All stocks are subject to market volatility, but companies that have a history of steady dividend payments tend to be mature businesses. Such firms typically have steady cash flows, reasonably stable profits and less operational risk than companies that don’t pay dividends.

This combination benefits shareholders, according to the report: “These characteristics have generally led to less volatility in dividend growth rates relative to earnings growth rates and to lower share price volatility for dividend-paying companies compared to the broader market.”

Dividends have been a major component of equity returns. It’s easy to overlook dividends during exceptional bull markets like 2013. That’s shortsighted reasoning, though. Dividends historically have accounted for a significant part of the stock market’s total return, though the percentage varies over time.

The focus on the income component in total return is another factor in favor of dividends, says Fidelity: “Moreover, a portfolio tilted toward dividend-paying equities may expect to get a greater proportion of total return from income—which depends on less volatile dividend growth—than price appreciation—which we believe is primarily driven by more volatile earnings growth.”

Sticking with Quality

Over 80% of the S&P 500 stocks currently pay dividends, but that doesn’t mean all dividend stocks are the same. U.S.-based dividend investors—and the market—value consistent and increasing payouts.

Foreign companies frequently adjust their dividends to reflect current profits; but most U.S. companies strive for payout consistency, because a dividend cut can cause a large drop in a stock’s price.

The Nasdaq OMX Dividend Achievers’ component companies have achieved that consistency for their shareholders. According to the Nasdaq OMX website, the Dividend Achievers’ history goes back to 1979, “when Moody’s Investor Service developed a proprietary model to identify best-of-breed dividend-paying companies.”

In 1998, Mergent Inc., acquired Moody’s Investor Service and rebranded its products and services with the Mergent name. Nasdaq OMX acquired that brand in late 2012 and added rules-based methodologies to make the indexes “more transparent for investors.”

Mergent continues to publish the quarterly “Handbook of Dividend Achievers,” which provides details on the qualifying U.S. and Canadian companies. According to the spring 2014 issue, a U.S. publicly traded company must trade on a major exchange and have increased its dividend for the last 10 or more consecutive years to qualify for inclusion. Canadian companies must meet a five-year hurdle.

Most companies don’t make the cut: Only 10% of the 3,300-plus North American-listed, dividend-paying common stocks get classified as Dividend Achievers.

Making the Grade

The Nasdaq OMX group licenses multiple indexes based on the Dividend Achiever methodology to ETF and mutual fund companies. The indexes have slightly different qualifications adapted for their component securities, although the central theme of consistent dividend growth applies to all the indexes.

Nasdaq OMX says that to be included in the U.S. Broad Dividend Achievers Index, a security must meet many conditions, including requirements that it have a minimum three-month average daily dollar trading volume of $1 million, have at least 10 consecutive years of increasing annual regular dividends and may not be issued by an issuer currently in bankruptcy proceedings.

Nasdaq OMX evaluates the index securities each March, based on the previous December’s values. Additions to and deletions from the index take effect after the close of trading on the third Friday in March. Included securities that fail to meet the requirements or cut their dividend by more than 50% can be dropped during the year.

Dividends’ Message

Because the markets dislike dividend cuts, companies’ boards tend to move cautiously when setting their dividend policies. As a result, the decision to start paying or to increase a dividend makes a positive statement about management’s outlook, observes Joe Becker, equity income specialist at Invesco PowerShares in Downers Grove, Ill.

Dividends are one of the two main ways that companies can return capital to shareholders, he says. Companies that pay consistent or growing dividends are signaling a degree of confidence that the business is sufficiently profitable to maintain or increase the dividend. In contrast, management wouldn’t increase a dividend if it had a negative outlook.

Jim Morrow, portfolio manager of Fidelity Advisor Equity Income Fund in Boston, shares a similar opinion. Dividends signal that the company is producing sufficient cash flow to actually pay the dividend—companies that are losing money do not pay dividends. Also, companies that have very volatile cash flow streams tend not to pay dividends.

Dividends also provide insight into management’s thinking about a company’s relationship with its shareholders. Dividend-payers’ view of capital allocation includes sharing excess cash with shareholders, and that’s a “huge positive attribute over time,” says Morrow.

In his experience, companies’ return of capital to shareholders tends to be good for stocks over long periods of time for several reasons. “Number one, they tend not to make dumb acquisitions or make silly decisions with their capital because they’re disciplined about returning capital to shareholders,” he says.

“And, number two, the management team is sort of signaling to you that they have confidence themselves in their cash flow profile and that they’re willing to make a commitment to the marketplace through the form of a dividend,” Morrow explains.

Corporate Commitment

Corporate managers recognize the signaling role that dividends play and can structure their business activities in a way that supports dividends. Each company, of course, has a unique outlook, strategy and method for supporting dividend growth.

Questar Corporation in Salt Lake City reorganized in 2010 by spinning off its exploration and production operations to create a more utility-centric company, according to Anthony Ivins, vice president, investor relations and corporate treasurer.

In doing so, the company sought to grow its dividend faster than earnings growth, to a level competitive with similar companies. Questar has since raised its dividend by nearly 50% since the reorganization, targeting a 60% payout ratio, which has now been achieved.

In the case of San Dimas, Calif.-based American States Water Company, growing utility and contracting- services business has allowed it grow its dividend, according to CEO Robert J. Sprowls.

Dividends & Total Returns

Dividend yields vary when looked at with from either a short- or long-term perspective, Morrow observes. Still, over any rolling 30-year period, dividends have supplied about 40% to 45% of the stock market’s total return.

In some decades—the 1930s, for instance—dividends supplied most of the return, while in the 1990s it was more like 15%. For long-term investors, however, dividends have been “incredibly important in terms of what people actually get from holding stocks,” he emphasizes.

Dividends & Stability

Those characteristics can result in lower stock price volatility. Morrow gives an example of investors applying suitability screens to their potential purchases.

They can start by eliminating companies that have volatile cash flows and can’t pay dividends. Next, they eliminate companies that have management unwilling to share capital with shareholders, because such firms are more interested in making acquisitions or managing other capital-consuming projects.

“What you’re left with is an inherently less volatile group of stocks than the market in the aggregate,” he says. “And that’s why the return profile for dividend-paying stocks has better risk-adjusted return characteristics.”

Jeremy Schwartz, director of research with ETF-sponsor WisdomTree in New York, cites research showing that higher dividend-paying stocks have been less volatile over time.

That result makes sense, Schwartz says, when you assume that a higher starting yield removes a level of uncertainty from the valuation equation. Essentially, there is less uncertainty around dividend-paying stocks’ future returns because of their yield.

That reduced uncertainty is reflected in the stocks’ reduced volatility. Over the last three to five years, he says, the volatility of dividend-paying stocks has been from 15% to 20% lower than that of the broader market indexes.

John Crawford Jr., director of equity investments with Crawford Investment Counsel in Atlanta, also views dividends as an important indicator of financial stability. He believes companies that can pay and sustain a given dividend —particularly those that can consistently increase the payout—generally have rising earnings and rising cash flow.

Both of these factors indicate a high level of consistency and/or quality. A lower-risk business or a more consistent business should lead to a more consistent pattern of earnings, he observes, which should produce a more consistent, or less volatile, share price.

“I think the dividend is a reflection of the type of business and that works its way into a lower-volatility profile on the share price in general,” the expert says.

Inflation Hedge

Inflation poses a continual challenge for income investors. Bondholders see the purchasing power of their principal and fixed interest payments erode over time, even at relatively low, steady rates of inflation. Stocks, however, are an “incredibly natural inflation hedge,” says Morrow.

The reason? Corporate financial results are denominated in nominal dollars. As inflation accelerates in an economy, revenues, stock earnings and stock prices also tend to inflate nominally with inflation. That doesn’t generate real (inflation-adjusted) profits, he acknowledges, but it is a natural hedge.

Morrow points to the 1970s as a decade of high and persistent inflation. During that period, stocks outperformed bonds quite materially, he says.

“Stocks outperformed inflation, so you got positive real return; and the best-performing subset of stocks during the ‘70s inflationary period was [that of] dividend-paying stocks,” he explains.

High dividend-paying stocks outperformed the broader market during that time, because they were producing income that was denominated in nominal dollars. Dividend growth accelerated during that inflationary period, he notes, providing a hedge against inflation.

Dividend-Growth Outlook

Projected dividend growth is another reason payouts should stay ahead of inflation, for at least the near term. S&P Dow Jones Indices reported that in the second quarter of 2014, 696 U.S. companies raised their dividends, and only 57 lowered or suspended them. That was the highest number of increases since 1979, and the outlook remains positive for the rest of the year, according to the company.

In addition, dividends are returning to historical norms, says Morrow. In the 1950s and 1960s, the S&P 500′s payout ratio averaged 55%. The rate declined in the 1980s to about 45% and fell even more in the 2000s, bottoming out at about 28% in 2009.

Throughout much of the 2000s, Morrow says, the rate was only about 30%. That trend, fortunately, now appears to be reversing itself. The trailing-12-month payout ratio has moved up from 28% to about 32 or 33%, he says, and for the last two or three years the S&P has started to grow its dividend per share faster than its earnings per share.

One reason for the higher payouts is that the financial crisis made investors very skeptical of corporate management and of the investing environment. As a result, shareholders are pressuring companies to return capital, either through buyback or dividends, and they’re rewarding compliant companies in the marketplace with higher valuations.

Thus, CEOs have an incentive to move their stock prices higher, and if the market is rewarding dividends, companies will deliver dividends, he says.

Another factor behind higher payouts is what Morrow calls “latent capacity.” Companies’ underlying dividend capacity, which is their ability to pay a dividend at a normalized rate, is as high as it’s ever been, he says.

U.S. corporate cash flow margins are “extraordinarily high” today, but companies aren’t reinvesting at a very rapid rate. He cites this excess capacity as another important reason for the recent acceleration of dividend growth relative to earnings.

Overall, says Morrow, the signs point to higher dividends. “If dividend payout ratios were just to return to 40% from where they reside currently, you’d see the yield on the market go up into the high twos,” he says.

“High twos in the current yield environment is pretty attractive, and current yields are the second sort of major factor that we think are causing companies to start to pay higher dividends,” the expert explains.

The market—and this is true of all asset classes—is starving for yield and the biggest potential source for cash yield in the world is U.S. corporates. They sit on huge cash flow margins, they have the ability to pay out and they’re starting to respond to those market signals,” he concludes.