Friday, February 10, 2012

To Dividend or Not to Dividend, That Is the Question?

To dividend or not to dividend, that is the question?  In 2011, most of what we have been saying about dividend stocks for the last 15 years came into full view for everyone to see.  In a weak stock market, the cash payments distributed by dividend-paying companies were more highly valued than betting on the come with the non-dividend payers.  During most of the year, the dividend yields of many stocks were higher than the yield on a 10-year U.S.Treasury bond.  This fact alone lifted many consumer staple, energy, health-care, and utility stocks.  Taken as a group, dividend-paying stocks significantly outperformed non-dividend paying stocks.

In 2011, dividend-paying companies, particularly those that have a history of consistently raising dividends, gradually were seen to be bond substitutes.  This is due to the compounding effect of rising dividends.  A company with a 3% dividend yield today will be yielding 6% in ten years if its dividend grows at a 7% annual rate.   A company yielding 2% today with its dividend growing 12% per year will yield near 7% in 10 years.

During the year, dividend paying stocks became the equity asset of choice.  There was almost a perfect symmetry between dividend yield and total return:  The higher the stock's dividend yield, the higher was its total return for the year.  For example many utilities enjoyed total rates of return of 15% or more in a year when the S&P 500 grew by about 2%.

But here in 2012, the robust early gains for the S&P 500 (5%) and the Global Dow (10%) have presented investors with a very difficult question:  Do we continue to focus on the "knowns"of dividend investing, or do we abandon them for the  "unknowns"  of gut feelings and hot tips?

The reason this question is so important is because the impressive stock market gains in the new year have caused many strategists to raise their estimates of 2012 stock market performance to 15% or more.  A 3% dividend yield looks good in a 2% stock or bond world, but it does not stack up so well against 15% returns.  Because of this many articles have been written arguing its time to move away from dividend investing and start pursuing growth again.

We would argue that dividend paying stocks are likely to perform just as well as non-dividend payers, even if stocks rise by 15%.  The reason is simple, our valuation models now predict that the average stock in our portfolios, which has a 3.5% dividend yield, is undervalued by almost 25%. You must remember, we focus on rising dividends.  To achieve a steady stream of rising dividends, a company must also have a solid stream of growing earnings.

In short "To Dividend or Not to Dividend" may be a false question.  Dividend-paying stocks can offer market-type returns when stocks grow by up to 15%.  In our experience, dividend-payers only begin to lag the overall market when the S&P 500 grows by 25% or more.  Even then, they will get most of the gains.

Considering how well the dividend payers do in down markets, and in view of all of the uncertainties in the world, we still believe "To Dividend" is the right answer for most people.    

We own dividend-paying stocks.