Has the dividend story been played out?

With so many investors moving to dividend-paying stocks and the equity market rebounding substantially from its global financial crisis lows, it may be fair to ask if the dividend strategy has been played out. A fair question, sure, but history shows that dividend-paying stocks can be the smart choice for long-term investors. Indeed, far from being played out, the dividend-paying stock strategy now being pursued by so many arguably may still be in the early stages. After strong relative and absolute performance in recent years, dividend-oriented stocks may appear expensive relative to other stock sectors on a price-to-earnings (P/E) basis. And Federated appreciates that, as more money flows into dividend-paying stocks, it would seem this relative valuation risk only grows.

But as this paper will explain, this view not only is short-sighted, but also assumes that flows into dividend-oriented stocks represent “hot’’ money—that is, money investors may plow into the “flavor of the day” and pull out just as quickly. That’s not what dividendoriented investors are all about. They tend to be long term in their thinking about investing, choosing companies they believe can stand the test of time and pay them income along the way. Moreover, while dividend-oriented securities’ valuations may seem high relative to other equity sectors at this particular time, research shows that current expectations for other market sectors are very high and that, should those expectations pull back, the dividend play would continue to be prudent. In fact, in such a scenario, dividend-paying stocks may even look cheap by comparison.

Historically, dividends have delivered
“A common perception among investors about total return is that 57% of return comes from capital appreciation and just 43% of return comes from dividends,” said Linda A. Duessel, senior equity-income market strategist at Federated Investors. “That conventional wisdom couldn’t be more wrong. The reality is that 90% of returns since the 1920s have been from dividends and dividend growth, not from capital appreciation.” In other words, a dividend-oriented investing strategy tends to generate more predictable and better returns over the long term than a strategy geared solely at price appreciation. Perhaps it’s understandable why today’s investors hold the opposite view. Most grew up during the secular bull market of the 1980s and 1990s, an era of the tech-stock explosion, when stock valuations and returns were exceptionally strong. Since then, of course, a decade has been lost.

The truth is that over the long haul, income has come from dividends and dividend
growth. Before 1980, the S&P 500 dividend yield—the amount that S&P companies paid out in dividends relative to their stock price—was 4%. Today, that yield is 2%. Also before 1980, the average payout of earnings as dividends was 55%. Today, it’s a record-low 27%. So if one believes companies will move toward their long-term trends, as we believe they will, and if one accepts that a dividend-oriented investing strategy pays—pardon us—dividends over the long term, then it would appear the shift by companies back toward dividends is still in its early stages—a very positive development for long-term investors.

And today, dividends are hot, again
After years of investor and company management focus on share price fluctuations rather than return on investment, companies are starting to see dividends as a way of returning real value to shareholders. And it’s no surprise. Corporate balance sheets hold $3.7 trillion of cash, $670 billion above 2007’s previous peak.

Standard & Poor’s says investors could expect to see dividend payments from the S&P 500 Index increase 15% this year. The forecast was based on dividends that have already been announced and adding in expected dividends from companies that have regularly paid dividends in the past. According to the analysis, dividend payouts by S&P 500 Index companies have reached an all-time high, with an annual dividend rate of $29.02 per index share. Three-quarters of the S&P 500’s dividend-paying companies increased dividend payouts over the prior year’s figures. And last year brought a record 22 dividend initiations by companies in the S&P 500, with five already in 2012. Adding to that figure, banks are also starting to return higher dividends, with nine out of the top 15 banks in a position to do so after passing the Federal Reserve’s recent stress tests.

Even historically stingy technology companies are adding to the movement. Apple’s decision to declare a dividend for the first time in almost two decades made big news, and its subsequent announcement of higher than expected secondquarter earnings brought calls for even higher dividends. “Apple is hot,” said Duessel. “Its iPod, iPhone and iPad literally changed entire industries. Other companies are looking to what Apple does, so this move could be influential.”

Other tech companies are feeling the pressure on dividends, as well. Cisco Systems regularly pays dividends, and has been urged by analysts to increase those dividends even higher. Microsoft recently raised its dividend by 25% to yield 3%. Even Google is likely to come under pressure to at least think about a dividend. As of the end of 2011, Google was sitting on almost $45 billion in cash and facing pressure from shareholders.

With the S&P 500 payout ratio at a record low and record cash on corporate balance sheets, companies have significant potential to grow their dividends, and significant incentives for doing so. Research shows companies that are simply sitting on their cash have been most heavily penalized in this market, while those companies with the highest payout ratios are enjoying the market’s highest valuations.

Investing, rather than simply trading
Some investors look for a trading environment in which you buy low, sell high, and do so frequently. They are not interested in the fact that by owning shares, they become an owner of a company that might or might not have longterm prospects for them. Using the stock market to invest in companies, and take an ownership stake in companies, is a different concept. As an owner of the company, you understand what they do, you understand they are profitable and as a consequence of being profitable, can send you a profit distribution every quarter. Dividend investing is using the stock market instrumentally—not investing in the stock market but investing in companies through the stock market to become generally long-term owners.

The question becomes one of balance. For most investors, using the stock market as a speculative platform is probably not a good idea. Instead, they prefer to use the stock market as a means of taking an ownership stake in corporations they did not create or otherwise could not own and, in the process, participate in the long-term growth of the companies and collect their profit distributions.

A sign of good health
Dividend-paying companies show they are responsible. They are not hoarding cash, and are confident enough in the future that they can make distributions to shareholders, while still pursuing new opportunities for growth.

Strong dividend-paying companies are generally healthier companies, too, in that corporate management does not have to worry about ups and downs of the stock price—they know investors will still see some benefit from dividend payouts. According to recent studies, companies with the highest payout ratios benefited from the highest valuations. When dividing dividend-paying S&P stocks into four quartiles, the top quartile has outperformed the bottom quartile by 3.4% annually since 1985. The top quartile also has tended to outperform during both bull and bear markets, with the ratio of high yielders to low yielders increasing 2.0% per year during bull markets and 8.9% per year during bear markets.

Dividend investing — a strategy for all seasons
In 2011, the S&P 500 began the year at 1,257 and ended, a year later, at almost exactly the same place. Of course, the market had a lot of hurdles to overcome: the uncertainties of raising the U.S. debt ceiling, the downgrading of the longterm credit rating of the U.S. and concerns that a Greek sovereign debt default might contaminate the rest of Europe. There was a general lack of confidence. From the beginning of August to the end of the year, the market saw more 4% swing days than ever before in the history of the market. And yet, despite all that turmoil, the market finished the year flat. The only way to invest, and the best way to get returns last year, was by using the defensive strategy of dividend investing. And while there have been signs of life in the market this year, it’s likely that the recovery will be plagued by periods of uncertainty and volatility.

A great part of the appeal of dividend stocks is that they work well with a wide range of investing profiles. Dividend investing is a strategy that may appeal to all types of investors, from short-term and intermediate to long-term investors.

Short
Short-term investors who look to current market conditions might shy away from dividend stocks, but they would be missing some important opportunities. Leading economic indicators peak, historically, about 6-8 months before a recession kicks in. Looking at the current market, they have yet to peak, but the pattern seems to show that they are potentially about to do so, possibly in the next 6-8 months.

Some believe we may be in the early stages of a secular bull market; others think we’re simply in a cyclical bull within the late stages of a secular bear market. It still seems too early to know which side may be right, which implies uncertainty and thus more of a sideways market until the dust settles. Historically, dividend stocks have proven to be a good place to make money in a sideways market. Should the decline continue into a full-fledged recession, and stocks decline, 100% of returns would come from dividends.

Intermediate
Intermediate-term investors also have reason to like dividend stocks. On an intermediate-term basis, the U.S. economy may resemble Japan’s economy. In the next five years, the question of how the U.S. is going to deal with its debt will become much clearer. In those next several years, the market may experience a wide sideways pattern, much like what’s happened in Japan since the early 1980s. During that period, someone who had invested in the Nikkei would have seen little growth.* An investor who had purchased high-dividend-paying stocks, on the other hand, would have had just under 10% annualized returns.

Long
Long term, dividend stocks may be a good idea for a number of reasons. First, there may be widely differing opinions on market outlook, but everyone can agree on one fact: the United States is heavily in debt, more heavily in debt than ever before. The odds of leaders being able to reasonably reduce the debt trajectory are not good. The U.S. will be borrowing beyond its means for the foreseeable future, mainly from China, from whom it already borrows approximately $6 billion every day simply to pay the interest on the debt.

In the longer term, the market seems to be moving toward a period much like that before the 1980s. During that period, the country was in a recession 45% of the time. And in that type of long-term market, the average investor is uncomfortably close, in any recovery, to the next recession to come along. Investors won’t be able to see enough sustained growth in the economy or even strong enough advances to get P/E multiples expanding. The only way to get paid in that type of environment is by dividends and by growth of dividends.

The taxman cometh?
Of course, no discussion of dividends could be complete without mentioning the possible expiration of the 15% cap on the dividend tax rate. Without congressional action, the dividend income marginal tax rate could jump to 39.6% for individuals earning $200,000 a year and for combined income above $250,000 for 2013 and beyond. Added to that is a 3.8% tax, embedded in the 2009 Patient Protection and Affordable Health Care Act, that will be applied to all investment income. This would take the tax rate from 15% to 43.4%, a near tripling. It’s too early to tell, however, which way Congress might go on this issue. Congress has an established history of putting off hard decisions, especially in election years, and they very well could come to some sort of solution, such as a temporary extension, that would push the decision out a few years.

Even if Congress allowed the cap to expire, dividend-paying stocks will still be worth looking at. The dividend play performed well even before the mid-1980s, an era when tax rates on dividends topped 50%. And if rates do go up, the highest rates would apply only to the highest earners, and a large percentage of dividend stocks are held in tax-deferred accounts. Tax increases on dividends would not necessarily translate into a serious decline in share prices, and may, ironically, offer a buying opportunity for the dedicated, longterm investor. The companies that are the highest payers are also, quite often, the strongest, most stable companies in the market, the ones that show the most fiscal restraint, and offer more than just dividends to entice shareholders.

Dividend investing is not a fad, according to Duessel. “If it’s a ‘crowded’ trade, it’s only because an increasing number of investors are recognizing that it’s a trade that – yes – pays dividends.”

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