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The Case for Dividend-Paying Stocks, Now and Later

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Financial advisors concerned about the outlook for stocks given the length of the current bull market — now in its seventh year — expectations of a Federal Reserve rate hike and a slowing U.S. economy might want to consider favoring dividend-paying stocks for their clients.

In their latest note to clients this week, Goldman Sachs equity strategists wrote that dividends and buybacks will be “the sole contributor to the total return in stocks for the next 12 months” because stocks are expensive. The median stock in the S&P 500 is trading at 18.2 times earnings — the 99th percentile of historical valuation price-to-earnings ratio, creating a “limited scope for further upward expansion,” according to Goldman.

There are other reasons to favor dividend-paying stocks this year:

—The yield on the S&P 500 is 1.92%, which, according to John Buckingham, chief investment officer of Al Frank Asset Management, is competitive with the 2.2% yield on the 10-year U.S. Treasury. Moreover, stocks have a much greater potential for capital appreciation than Treasuries.

— Stock dividends have been rising and could rise more this year. Buckingham says 381 companies in the S&P 500 hiked dividends in 2013 and 375 did so last year, but “payout ratios are still relatively low so corporate America continues to have the capacity to increase dividends.”

Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, says companies paid out a record $93.6 billion in the first quarter, continuing a trend of rising quarterly dividends that began two years earlier and has room to grow.  “Investors are getting more than they ever got before, but that doesn’t mean companies are being generous,” says Silverblatt. “Companies are paying out only 37%-38% of GAAP earnings to dividend holders, but historically they paid out 52%.”

Dividend-paying stocks, like many stocks, have historically performed well in past periods of rising rates, despite reports to the contrary, says Buckingham. The key for performance will be earnings. “If the stocks have higher growth rates, and can raise the dividends as interest rates rise, these stocks will be less sensitive to interest rates and likely a good place to be invested,” writes Ryan Wibberley, CEO of CIC Wealth, a financial advisory firm in the Washington, D.C. metro area, in Forbes. Six months before and 12 months after, stocks overall have gained ground, notes Buckingham.

But if stock prices fall this year—because of earnings disappointments, a long overdue correction or a Fed rate hike — dividend-paying stocks could still perform relatively well because their payouts will cushion losses.

Source: AFAM Capital

— Dividend-paying stocks outperform in the long run. Looking beyond this year, Buckingham says dividend-paying stocks are a better investment for the long term. From 1927 through 2014, dividend-paying stocks have had an annual total return of 10.4%, trumping the 8.5% for non-dividend payers, says Buckingham, citing data from famed value champions Professors Eugene Fama and Kenneth French. The larger the dividend, the greater the outperformance, says Buckingham, who hosted a webinar on “The Case for Value Investing in 2015 and Beyond,” which focused largely on the appeal of dividend-paying value equities.

— Dividend payers are less volatile. The volatility of dividend payer, as measured by standard deviation, is 18.3% compared to 30.1% for non-dividend paying stocks. That could calm investors’ fears during a market correction, which is not unexpected.

“Given the historical evidence, we believe that dividend payers deserve a large portion of any equity allocation,” says Buckingham.  He favors dividend-paying value stocks, which have outperformed growth stocks 80% of the time, though not lately. “The fact that value has underperformed increases the odds in favor of value versus growth,” says Buckingham.  

Longer term, says Buckingham, “while not risk-free, of course, neither value nor dividend stocks as a group have ever lost money for those who held for 15 years or longer.”

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