Today’s income-oriented investor has an unprecedented variety of income- paying investments to choose from: there are bonds and bond-based funds, of course, but there are also MLPs, BDCs, preferred stocks, REITs, income trusts and more. But while the yields on these instruments can be quite tempting, there’s still something to be said for good old dividend-paying stocks. They offer growth potential you can’t get with most other income investments—and they’re our bread and butter here at the Digest. Below, two of our contributors explain why now is a great time to invest in dividend-paying stocks.
“For many, the phrase ‘dividend-paying stocks’ inspires thoughts of financials and utilities, sectors known for high yields. However, those two sectors currently account for less than one-fifth of the cash dividends paid out by S&P 500 Index companies. For stock investors seeking income, sectors not generally associated with dividends represent a rich hunting ground. In the 12 months ended June, S&P 500 Index companies paid out $197 billion in dividends, down $25 billion from the year-ago period. Financial stocks accounted for almost all of that decline, with 61% of S&P 500 financials paying less over the last year than they did in the prior-year period. Three years ago, the financial sector alone accounted for more than 26% of the S&P 500 Index’s dividends, versus a combined 44% for the consumer discretionary, energy, health-care, industrial and technology sectors. Over the last 12 months, those five sectors accounted for 52% of dividends, while finance’s share has dropped to 10%. It’s understandable many dividend-oriented investors don’t turn to health care and technology, as the stocks in both sectors of the S&P 500 average yields of less than 1%. But ignoring those ‘low-yield’ sectors is foolish for two reasons:
• First, averages can mislead. Yes, the average S&P 500 health-care stock yields 0.9%, while the average tech stock yields 0.7%. But fewer than 50% of those stocks pay dividends, which drags the averages down. The average dividend-paying health stock yields 2.1%, versus 1.8% for tech stocks.
• Second, diversification is crucial. Shrewd investors spread their funds around numerous sectors to limit exposure to weakness in a particular sector.
• Third, good stocks abound. By limiting yourself to ‘high-yield’ sectors, you ignore sectors with strong Quadrix scores and excellent profit-growth potential. On average, health-care and technology stocks in the S&P 500 earn Quadrix Overall scores of more than 71. In contrast, financials and utilities average scores below the average of 62 for the entire index.”
Richard J. Moroney, CFA, Dow Theory Forecasts
Turnaround Letter Editor George Putnam wrote recently about why now is a terrible time to invest in bonds— partly because of their popularity, and partly because of interest rate risk. Below, he outlines the benefits of dividend-paying stocks as an alternative. Four of his nine dividend-paying stock recommendations are included (please note that his averages are for all nine).
“Instead of buying bonds, you can put income and some downside protection into your portfolio by buying stocks in high quality companies that pay generous dividends. Unlike bonds, these stocks give you long- term appreciation potential. (While bonds may move around in price, ultimately you will not get back any more than the face or principal value of the bond, plus the interest that is paid along the way.) They have the further benefit (at least for the time being) that dividends are taxed at a lower rate than bond interest—the top tax rate on dividends is currently 15% versus 35% on bonds.
“The stocks discussed below pay an average dividend of nearly 4.9%, which is a full point higher than the yield on a 30-year U.S. Treasury bond today. While they would certainly fall in any broad stock market decline, they would probably fall less than the typical stock. For example, during the six-month period from September 1, 2008, through March 1, 2009, the stocks below declined by an average of 31% compared to 43% for the S&P 500. And they are likely to be considerably less sensitive than most bonds to a move up in interest rates. For example, during the last period of rising rates (from July 2005 to July 2006), the Barclays Aggregate Bond Index fell by 5.8%, but [our featured] nine stocks … that were trading then gained an average of 3.7%.
“AT&T, Inc. (T 27.03 NYSE – yield 6.20%) and Verizon Communications, Inc. (VZ 30.02 NYSE – yield 6.30%) are the two survivors of the telephone industry’s merger frenzy. Though both companies are reducing their dependency on land-line connections, the sector remains a good source of cash flow. The battleground has shifted to the wireless and high-speed data and video markets, where expanding services will fuel growth. AT&T is the whole owner of its wireless service business, while Verizon owns 55% of Verizon Wireless. Both companies have incurred large capital expenditures in recent years to build the infrastructure to support new services. Nevertheless, their balance sheets remain healthy enough to support the generous dividends.
“American Electric Power Co., Inc. (AEP 36.27 NYSE – yield 4.60%) and Exelon Corp. (EXC 42.63 NYSE – yield 4.90%), though both substantial energy providers, come at their business from different vantage points. American Electric uses lower-cost coal while Exelon is the nation’s largest nuclear operator. Nuclear power is more capital intensive, but it also has lower risk exposure to federal legislation seeking to oversee greenhouse gas emissions. We’d expect American Electric to pass through any increased costs, and the risks are somewhat discounted already. A general rebound in economic activity would provide a boost to each of the stocks. But in the meantime, the strong dividends should maintain investor interest.”
George Putnam, III, The Turnaround Letter