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Guide to Dividend Investing

28 April 2014 in Trading Ideas

The “easy money” era hasn’t been so simple for everyone.

While historically low interest rates have been held in place in an attempt by the Federal Reserve to encourage borrowing and stimulate the US economy, it’s meant leaner times for those investors who have settled – or would like to soon settle – into retirement on conventionally safe investments like a money market account, CDs, or US Treasuries.

The returns for many just haven’t delivered, and as a result, many investors seeking income have turned to dividend-paying stocks in an attempt to capture a more predictable source of income and as a hedge against market volatility.

But why stop there? For some investors, aligning with dividend-paying stocks also means you’re seeking to add more stable companies to your portfolio – and with it, the intended hope that these stocks can also appreciate under the right market conditions. After all, it tends to be well-established companies with strong track records that are able to pay (and keep paying) dividends.

With the “graying” of America, it is not surprising that increasingly more investors have been chasing income-generating assets amid this period of relative low interest rates. In fact, dividend income as a percentage of total US personal income has been steadily increasing, rising to 6.12% in 2011 from 3.58% in 1991.1

What’s more, dividends have generated a significant portion of the stock market’s historical return. Consider this: dividend income represents 34% of the S&P 500’s total monthly return between 1926 and 2012.1

The Future For Dividends

Of course, the question now facing investors, particularly those who haven’t been considering dividends up until now, is whether conditions figure to remain favorable for dividend investing in the years ahead.

Industry analysis suggests that several fundamental reasons may remain in play that could contribute to the ability of dividend-paying stocks to deliver value to investors over the next few years:

  • Historically low dividend payout ratios. The average payout ratio by companies – the percentage of income paid out as cash dividends – is near historic lows, while the amount of cash on corporate balance sheets is sitting at an all-time high of $1.5 trillion.2 As earnings grow, the demand by investors for income and yield may push companies to start or boost payouts. In 2012, dividend initiations by companies reached an 18-year high.
  • Low yield environment. The bond market continues to offer relatively low yields, and that can help make dividend payouts appear comparatively more attractive. For example, many dividend-centric investments, such as REITs and MLPs, are seeing strong investor demand with payout yields of 4%-5% on an annualized basis.3 By comparison, interest rates on the 10-year US Treasury have mostly hung below 3% over the past two-and-a-half years.
  • Favorable tax treatment. After the “fiscal cliff” fallout, the tax situation for dividends is much clearer. Dividends will be taxed at a lower rate than ordinary income – 20% vs. up to 39.6%, which can make them, on a strictly numbers basis, appear more attractive than debt-generated income on an after-tax basis.4
  • Demographics. This just in: we’re getting older as a country. About 7,000 to 10,000 Baby Boomers will turn 65 every day from now until 2030.5 As this generation retires and lives longer, the need for income generation and capital appreciation could rise. which could continue to trigger investor interest in dividend-paying stocks.6

Slicing The Dividend Pie

The dividend-focused motifs that you’ll find in our catalog focus on three key factors: stability, growth and yield.

Stability refers to how steady the dividends have come from an individual company. Stable dividends can often represent a well-established company that has demonstrated predictable cash flows through the ebb and flow of several economic cycles. Our Defensive Dividends and Dividend Stars motifs includes stocks of companies that haven’t cut dividends in more than a decade. In addition, these portfolios have been screened for companies that have shown strong balance sheets and cash flows over time.

Growth is how a company’s dividend payout appreciates on an annual basis. Growing dividends can be a sign that a company expects its business to grow in the future. Our Growing Dividends motif consists of companies that have consistently grown dividends over the past five years and which have shown rising cash flows. Historically, companies that have initiated or grown dividends returned 9.5% per year, on average, between 1972 and 2012, compared to 7.2% for companies maintaining dividends, and -0.3% for dividend-cutting companies.7

Yield may be most sought-after parameter – and also the most dangerous. Since it is highly sensitive to stock-price movements, investors risk falling into a “yield trap” – favoring a high-yielding stock which has seen its price depreciate significantly. Our High-Yield Dividends motif addressed this concern by screening out stocks that have underperformed the S&P 500 by more than 10% in the last six months, which can have the effect of artificially inflating yield. Companies in this motif haven’t cut dividends in the last 10 years and has offered a yield more than twice that of the S&P 500 average.

Check out our full selection of dividend-focused motifs.

1Dividend Investing and a Look inside the S&P Dow Jones Dividend Indices. Standard & Poor’s, March 2013

2Market Insight – Why Dividend Stocks are Paying Off. ING, February 2013

3Factset Data, April 2014

4Internal Revenue Services, http://www.irs.gov/publications/p17/ch08.html

5Cohn and Taylor, “Baby Boomers Approach Age 65.”

6D’Vera Cohn and Paul Taylor, “Baby Boomers Approach Age 65 — Glumly,” Pew Internet & American Life Project, December 20, 2010, http://www.pewinternet.org

7Dividends for the Long Term, JP Morgan Investment Insights, April 2013.

  1. Jason Ramage
    29 Apr at 3:06 am

    Good stuff. Another idea that would work pretty well in a motif are preferred stocks. There isn’t as much potential for capital gains, but they’re also more predictable and less prone to dividend cuts when cash flow gets tight.

    Also, I hope we’ll have the option to reinvest dividends soon. That will make the dividend motifs all the more attractive!

  2. adrian otto
    23 Jun at 12:41 pm

    i can only hope, dividend stocks is the right move.