Tuesday, September 20, 2011

The Case for Dividend-Paying Stocks

As I have written many times on this blog, record low interest rates may be good news for borrowers, but they represent a huge challenge for investors and savers.

In the traditional balanced portfolio, bonds typically act as a buffer against stock market volatility. In addition, up until recently, bonds offered investors a reasonable stream of income.

Now interest rates have plunged to lows not seen for over 60 years. The 10 year Treasury yields less than 2%, and rates are well below 1% for maturities under 5 years. Meanwhile, core CPI is running at 1.8%, which essentially means that bonds offer little or no real return.

In today's world, then, I continue to advocate that investors consider making dividend-paying stocks a larger part of their investment portfolio.

True, stocks can have more volatility, and, yes, it is certainly possible that if today's current economic slowdown turns into recession that stocks could struggle.

For an investor who needs to rely on their investment portfolio for at least a portion of their living expenses there are plenty of quality stocks that offer dividend yields above 3%.

Yesterday, for example, I ran a screen of stocks in the S&P 500. I wanted to find stocks that paid at least a 3% dividend yield and were selling at a P/E of less than 10x.

I came up with 24 different stocks that met this criteria. Names like Chevron; Eli Lilly; Raytheon; and Intel all met my measure. Moreover, most of the names I found had increased their dividends at least three times in the last five years.

And it turns out that over longer period of time dividend-paying stocks tend to offer better total returns to investors, as an article in last Thursday's New York Times indicated:

The key to building a dividend-rich portfolio, whether you buy individual stocks, mutual funds or exchange-traded funds, is to find companies that will pay consistently and increase their payments over time. This dividend growth strategy can partly offset inflation and dismal savings rates. Many dividend yields are three times or more what you’ll find in insured vehicles like money market accounts or certificates of deposit, albeit with some market risk...

Over time, this strategy has rewarded long-term investors. In a notable study by Robert D. Arnott, then the editor of The Financial Analysts Journal, dividends contributed five percentage points of the 7.9 percent total return in holding stocks from 1802 through 2002.


Oh, and one other point: if inflation were to start to creep higher, stocks could offer at least the possibility of capital appreciation to try to maintain real purchasing power.