August 21, 2014 at 12:00 PM
Investors have long had a love affair with dividend yielding stocks. The theory is that companies paying dividends usually are optimistic about both their business position and growth prospects. Companies that pay and more importantly, continue to increase their dividend rate, tend to outperform the market on a risk-adjusted basis.
Dividends connect you tangibly to the underlying results of the company. This may be because they have developed solid cash-generating businesses and stronger finances. The dividend also signals confidence from management, linking the return on that business to shareholders in a very practical and public way.
Who pays dividends? Most likely a company that is more mature, confident in its business model and operations, and generating significant cash flow. Utilities and financial companies historically have been large dividend payers. It is estimated that utilities represent anywhere from 10-30% of the dividend paying universe.
Provide a reliable income stream and give an investor control on how to redeploy it – Investors who want to generate a predictable cash flow love the stable and consistent income stream dividend stocks can provide. In addition, dividends put a portion of the company’s return on capital in your hands to reinvest as you wish. This is the opposite of having the company decide to purchase assets overseas, make an overpriced acquisition, or undertake some other action you may not agree with.
Mitigate some market risk - Dividend plays tend to do best in an uncertain market. When investors get skittish and market returns fall, the onus often rests on dividends to drive total stock returns. Dividends have contributed approximately 34% of the S&P’s total return since 1926. In periods of stock declines, such as the 1970s and 2000s, dividends were the only returns investors received.
Inflation protection - Dividends can also help counter the effects of inflation and protect purchasing power, especially if a company has a dividend payout rate that exceeds the inflation rate. Data from Yale Professor Robert Shiller indicates that over the past 100 years, dividends from a diversified collection of US stocks have grown an average of 4.4% annually, easily beating the inflation rate of 3.2%.
Favorable tax treatment - Interest from bonds and other fixed income investments is taxed as ordinary income at your highest marginal tax rate. Qualifying dividends will be taxed, along with capital gains, at a lower rate. Most dividends from US stocks should qualify for this treatment.
Rising rates –Rising rates can hurt dividend paying stocks in several ways. First, investors often view these stocks as a proxy for bonds and drag down the value in sympathy with bond prices. Second, investors may move to alternative fixed income products. Finally, a rising rate environment often signals a stronger economy, which favors growth stocks versus dividend payers.
A market that favors growth stocks - When the market enters its more active bull phase, dividend companies are often viewed as those stodgy old grandparents, slower-moving and graying around the edges. The more mature nature of the investment puts it at a disadvantage to younger and faster-moving growth stocks. Safety and security go out the window and these companies may trail the market.
The dreaded dividend cut – During the bear market that commenced in 2008, S&P companies cut their dividends by 24%, led mostly by financial firms. That was mild compared to what happened during the Great Depression when dividends were cut by 47%, even accounting for the period’s deflation. Dividend cuts impact valuations.
Investing in dividend stocks can be a profitable strategy that generates cash flow and provides stability during volatile market times. However, dividend investing is no guarantee of outperformance. You may outperform during volatile or down market periods, but underperform when the markets heat up. Finally, purchasing a stock for its dividend only is a risky strategy. Do your homework and find the solid company that has a demonstrated an ability and commitment to grow its dividend.
Note: Elaine Phipps, MBA, CFA is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit. The full-length version of this article is available at: www.ptview.com.