The advantages of dividend payers

Increased volatility in financial markets has put dividends back in the spotlight. These stocks have long been recognized for their defensive characteristics during bear markets, but their attractive combination of stable income and capital appreciation potential has also delivered strong returns throughout all market cycles. In this context, dividend investing seems particularly relevant in the current market.

Historical perspective

During the great bull market of the 1980s and 1990s, capital appreciation accounted for the bulk of stock returns, and investors were willing to forgo dividends. The mood of the decade that followed was very different. The 2000s began with severe losses in stocks triggered by the end of the tech bubble, and investors were suddenly reminded that stock prices don’t always go up. This painful lesson seemed to be quickly forgotten, however, as stocks rebounded fairly quickly and once again began to post impressive price gains. All that changed, of course, when the decade ended with the subprime market crash.

Dividend-paying stocks have generated solid flows regardless of market movements. According to ISI, dividends have, on average, accounted for about 50% of total stock returns.

Faced with slower growth prospects and more frequent extreme market fluctuations, investors value the predictability of dividends to stabilize and strengthen their stock returns.

A clear signal of the financial health of companies

Dividends increase the transparency of a company's earnings and exert a level of financial discipline on its management. They also increase corporate accountability and can be a signal of management's confidence in future growth prospects. For these reasons, companies are reluctant to cut their dividends.

An important source of total return

Dividends provide the potential for capital growth and income. Reinvested dividends have accounted for nearly 50% of total capital returns since the 1930s. The total annual return based on price alone is a meager 5.2%, compared to a comparative 9.4% when dividends are included.

Low volatility

Dividends cushion a portfolio's losses when stock prices fall. Over longer time horizons, stocks with high dividend yields have also produced better returns with lower risks.

Higher yields regardless of interest rate movements

With interest rates so low, many investors may be concerned about the impact that rising rates could have on stock performance. However, regardless of how the Federal Reserve changes monetary policy, dividend-paying stocks have consistently outperformed their non-yielding counterparts. For example, when the Fed tightens monetary policy dividend payers increase by 2.2% per year versus 1.8% for non-payers. During periods when monetary policy is neutral, the gain for dividend-paying stocks has been even more evident: 12.3% versus 6.2%. Finally, in easing environments it has been as much as 10.0% versus -2.5%.

Downside protection during turbulent market cycles

Investors often focus on the defensive benefits of dividend-paying stocks. However, dividend payers have outperformed non-payers in both bull and bear markets. This trend has been even greater for stocks that have increased their dividends over time. For example, companies that have increased or initiated a dividend have posted annual returns of $9.6% over the past 38 years. Stocks that have maintained their dividend over time have posted annual returns of $7.5%. Stocks that pay no dividends have stagnated at nearly $1.7%. Those that have either decreased or eliminated their distributions have been punished by investors, with annual losses of $0.5%.

All things considered, dividend stocks appear positioned to benefit from favorable momentum in the future. Today, with high volatility and more moderate market expectations than before, investors are increasingly reluctant to rely on capital appreciation alone.

Slowdown in economic growth

Concerns about the eurozone, stubbornly high unemployment and tepid consumer spending continue to worry investors, and it seems likely that full economic recovery is likely to remain elusive for some time. Dividends provide a degree of positive yield, even if share prices remain volatile or opportunities for appreciation are limited by slower economic growth.

Fewer attractive sources of income

There are few viable options for investors looking to stabilize portfolio performance while continuing to capture solid levels of income. At the same time, equity dividend yields have been close to U.S. Treasury yields since 2008.

Bond Market Concerns Grow

Over the past few years, investors have poured money into bond markets, and prices have risen significantly, rekindling fears of a bond bubble. There is little to no room for further rate cuts, and once rates start to rise, or if inflation risks rear their heads, the impact on bond markets could be devastating. Dividend payers thus help investors diversify their income-generating activities, thereby protecting them from a sharp decline in bond prices.

More companies are paying dividends

In recent years, with growing economic uncertainty, companies have become extremely cautious, building up considerable cash reserves. U.S. companies hold a record level of about $1.85 trillion in liquid assets. The ratio of cash to total assets is currently 7%, the highest level since the 1960s.

In addition, productivity gains and cost savings throughout the economic crisis have led to higher margins and cash flows. As a result, many companies can initiate or increase their dividends, boosting stock returns. According to Standard & Poor's, 256 S&P 500 companies took positive action on their dividends in 2010, while only five cut or eliminated them. The percentage of S&P companies that pay dividends has been declining since 1980, but it has been climbing since 2002, excluding a brief decline during the 2008 financial crisis.

Growing demand from investors

Dividend payers are likely to continue to capture the attention of retiring baby boomers and other yield-hungry investors. More broadly, investors are looking to supplement the performance of stocks based on concerns about capital growth prospects. This could lead to real opportunities for price appreciation.

Conclusion

In an environment characterized by greater stock volatility, low interest rates and slowing economic growth, investors may want to consider investing in dividend-paying stocks. The consistent income generated by these securities has historically helped mitigate exposure to price declines during difficult markets, but also improve profitability even during better times.

Most investors look to bonds for fixed income and stocks for capital growth. Dividend payers combine both attributes. By offering a powerful blend of income and capital appreciation, dividend payers have outperformed non-yielding securities, with less volatility. What’s more, some equity yields are now comparable to those offered by fixed income securities, which are likely to decline in value as interest rates rise.

Dividends alone, however, do not guarantee investment success. Companies that have consistently increased dividends have produced stronger long-term performance. Conversely, companies that have decreased dividend payments have been punished by investors. It is therefore essential to assess the sustainability of a company's dividend distribution, as well as its ability to increase it in the future.

Sources: 

http://econintersect.com/b2evolution/blog3.php/2011/03/15/benefits-of-dividend-paying-stocks-1

http://www.clevelandfed.org/~~V research/trends/2010/1210/01gropro.cfm