Dividend Investing

Dividend Investing

The era of ZIRP, easy money and financial repression has forced many savers/retirees to look elsewhere for yield/income. This has forced many investors to look at dividend paying stocks to capture a more predictable source of income and as a hedge against market gyrations.

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.

What’s more, dividends have generated a significant portion of the stock market’s historical return representing 34% of the S&P 500’s total monthly return between 1926 and 2012.

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 will 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. 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. 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.

Demographics. We’re getting older as a country. About 7,000 to 10,000 Baby Boomers will turn 65 every day from now until 2030. 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.

When looking for dividend focussed investments one should look for 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.

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. 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.

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.