Friday, February 3, 2012

Dividend Indigestion

Caroline Glen, UVA class of 2016
Easily the most popular strategy among my client base last year was investing in dividend-paying stocks.

This trend has continued in 2012.  Investors are frustrated with the low rates on bank CD's and money market funds, and bond yields are at post-World War II lows.

Buying a large cap stock trading at a reasonable valuation that also pays a nice dividend is a comfortable decision.  This is especially true when the stock offers a yield that is often higher than bonds offered by the same company, which is often the case.

Dividend-paying stocks were big winners last year.  Returns from "boring" utility stocks lead the S&P 500 in 2011, producing a total return of nearly +20%.  Consumer staples stocks - meaning companies like Colgate; General Mills; and Coca Cola - were the second best performing group, up by more than +12% last year.

Like so many things in life, however, too much of a good thing can cause indigestion, which now has occurred to the group of large cap dividend payers equities.

I noted in several posts on Random Glenings last month that the valuations of many of the stocks in the utility; telecom; and consumer staples had reached historically rich valuations, especially compared to other sectors of the market.

And now it seems that the market is rotating away from the dividend-payers, at least for the time being.  Here's an excerpt from a piece posted yesterday by CNBC:

Non-dividend-paying stocks on the Standard & Poor's 500 [.SPX  1343.88    18.34  (+1.38%)   ] are up 8.3 percent, while dividend payers are down 1.3 percent and the index as a whole is up nearly 5 percent, according to data from Bespoke Investment Group.

That marks a sharp contrast from 2011, when companies paying dividends jumped 10.4 percent, easily outpacing the market as investors clamored for the yield they couldn't get from fixed income....

...The dividend-payers are a subset of a larger group lagging a rally this year that has given the S&P 500 a 4.36 percent price return and a 4.48 percent total return including dividends.

The 50 stocks that gained the most last year rose just under 1 percent in January, while the 50 worst-performing stocks have soared 11.8 percent.

So is the game over for large cap dividend stocks?
I don't think so, especially if you are focusing on growing your portfolio while receiving a good cash yield on your investments.

To state the obvious:  the goal for most investors is to make money. 

Beating a market index like the Dow Jones or S&P 500 is interesting, but "maximizing real returns" (a term coined by investment giant John Templeton) is usually the most common objective for investing.

It is true that if the market continues its upward bias that money may continue to move away from safer equity sectors like utilities. 

However, in my opinion, this creates more of an opportunity than a risk, and so any significant price weakness should be viewed as such.

From a longer term perspective, nearly 40% of the long term returns from investing in common stocks has come from dividends.  Capital growth is important, to be sure, but when you start with a portfolio that is already generating significant dividend income the chances of a successful investment program are greatly enhanced.

So let the low quality, high beta stocks have their day - the race will inevitably go to the slow, consistent world of solid companies offering a reasonable combination of income and capital appreciation.