Wednesday, March 7, 2012

Interest in Dividends

by Matt Malick

“Do you know the only thing that gives me pleasure?  It's to see my dividends coming in.” - John D. Rockefeller

In the world of investments, everything is cyclical.  Hot trends inevitably cool off and passé ideas return to popularity.  Today, stock dividends have become the latest investment theme to regain favor.

As the last secular bull market was surging in the late 1990s, dividends became a mere afterthought and many analysts even condemned them.  Equities were easily achieving double-digit total returns year after year, making dividends seem relatively insignificant.  Furthermore, many market professionals suggested that corporations were better served using cash to fund acquisitions and other growth opportunities, a sign of rampant optimism.  The logic was that companies had superior internal investment opportunities and to return money to shareholders in the form of a cash dividend was actually a waste.  It was the era of the celebrity CEO who could make no bad decisions.

The next twelve years, however, were an entirely different story.  Equities entered a “lost decade” of relatively flat returns with the S&P 500 at roughly the same level where it peaked in 2000.  And instead of the public considering CEOs to be celebrated allocators of capital, they have gradually become bemoaned fat cats.

Ironically, since 2000, a point in time when dividends were largely ignored, virtually the only return that buy-and-hold equity investors reaped were from dividends.  This “reversion to the mean” phenomenon is not unusual, but always unexpected.

Today, dividends are experiencing renewed appeal throughout the investment community.  In aggregate, U.S. equity mutual funds suffered $103 billion in redemptions in the 12 months ended January 31, 2012, according to Morningstar.  But, nervous investors did not shun dividend stocks.  Just last year, mutual funds that focus on dividends attracted $3 billion in inflows and dividend-themed exchange traded funds took in another $14.3 billion.  There is often an inverse relationship between mutual fund flows and future performance – positive flows can predict underperformance, while negative flows can suggest outperformance.

Investment companies have identified the opportunity to appeal to yield-starved investors, launching 16 brand new dividend-oriented funds in 2011.  Even the Fidelity Equity Income Fund II, which appointed a new manager and increased its exposure to dividend-paying stocks, changed its name to the Fidelity Equity Dividend Income Fund.

Perhaps an interesting sign of the general hunger for dividends is the March 2012 cover of Investment Advisor magazine with its headline, “Dividends, Dividends, Dividends!”.  The assumption among the punditry is that - given below-trend economic growth and, at the same time, strong corporate balance sheets - future returns favor companies that return cash to shareholders.

Despite general enthusiasm, sometimes a contradictory sign, there is actually very sound logic behind dividend stocks.  According to Morningstar, “Since 1927, high-dividend-paying stocks have returned 11% per year, beating the 8% return from nonpayers and resulting in an ending wealth that is 8 times larger.  Better yet, they accomplished this feat while incurring less volatility.”

Furthermore, Ned Davis Research finds that between 1972 and 2005, S&P 500 stocks that had consistently grown their dividends outperformed the nonpayers by 6%.  And presently, the dividend payout ratio (the amount that a corporation distributes in dividends relative to its earnings) is at a historic low of 32 percent.  In the past, the average payout ratio has been over 50 percent.  This statistic implies that companies have plenty of room to raise their dividends in the years ahead.

Moreover, the tax rate on qualified dividend income – currently 15% for most taxpayers – is at an all-time low.

Finally, bond yields have become so paltry that dividends are an increasingly important source of income.  As of today, the yield on the ten-year Treasury stands at 1.97% whereas the dividend yield on the S&P 500 is 1.93% and offers the potential for price appreciation.

Yet, after turning in stellar performance relative to other equities in 2011, dividend stocks have not fared as well through the first two months of 2012.  According to Bespoke Investment Group, the  stocks in the S&P 500 that pay no dividend have outperformed the 50 stocks in the index with the highest dividends by a whopping 12.03%.

In our opinion, dividend-paying stocks serve an important role in a diversified portfolio.  In fact, our managed equity portfolio has a considerably higher average yield than the overall market.  But dividends are not a cure-all for apprehensive investors.  The consensus seems to be that dividend stocks are sure to hold their value, continue paying healthy yields and offer potential capital gains.

We urge caution that dividend-payers are still equities and carry the risk of loss.  And stock dividends are not guaranteed – just ask shareholders in most financial companies during the crisis years of 2007-2009.

Of equal importance, if the market performs well over the next several years, which is our expectation, investors will eventually take notice and start chasing returns.  Dividend stocks could easily trail the overall market if sentiment improves.  This is an important reason to hold a mix of equities in different businesses and with varying market capitalizations, geographic footprints and dividend levels.

The bull market that began in March of 2009 is now the ninth longest bull market since 1928, but the retail investor has still not returned.  For now, dividend paying stocks are the investor’s training wheels to get back into the market.  But if stocks have a big year of gains, greed can take over and folks may think they are riding in the Tour de France and toss the training wheels.

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