The Lure of Big Dividend Payers

09/09/2010 11:11 am EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor and publisher of NoLoad Fund*X, says big dividend-paying stocks are among the hottest groups she follows, and she explains why.

Larger-company stocks held up better in August as the Dow Jones Industrial Average lost 4.1%, the Standard & Poor’s 500 index dropped 4.6%, and the Russell 2000 sank 7.5%. The Dow Jones Global index, excluding the US, lost 3.5%.

After a strong rebound last year and despite better-than-expected earnings, the S&P 500 ended August down 5% for the year. The broad market index is now 17% below where it stood ten years ago.

[Yet] before-tax profits are up 39%, near the fastest pace since 1983. Analysts question why the growth in earnings has not translated to higher [stock] prices. While US companies announced record profits during the second quarter, and, on average, beat forecasts by a comfortable margin, the stock market still sank [last] month.

Part of the answer may be that stocks rose so swiftly off the March 2009 lows that they got ahead of fundamentals and were due for a pullback. This sideways market action has given underlying fundamentals a chance to catch up with stock prices.

And, stocks have gotten cheaper: The US market’s average price/earnings ratio has dropped 36% during the past year, the largest 12-month decline since 2003. It now stands around 15x, based on trailing-12-month earnings, compared with 23x one year ago.

While stocks can certainly get cheaper, historically if you pay below-average prices for stocks, especially if they pay dividends, you end up with above-average long-term performance.

Buying stocks is buying a piece of future corporate earnings. What you pay for that piece of ownership matters. Global companies are profitable. The question now is, what price are investors willing to pay to participate in those profits.

Surely a return to basic value is welcome in today’s uncertain world. After the lousy returns of the past decade, predictable earnings from 3% dividend yields look appealing.

Larger-company stocks trailed smaller stocks for the past decade and so far in 2010, but are now leading. In the ten years ended August 31st, the largest stocks lost 2% per year while mid-cap stocks gained 4% and small stocks rose 3% on average.

But that trend may be changing. In a slow-growing economy, the biggest companies can stand out because their earnings are more predictable. They often offer stable returns on capital and low debt.

Many see that large-cap blue chips are cheap after a decade in which their earnings grew while their stock prices did not. Many large, good dividend-paying stocks have yields higher than Treasuries. And because they are global companies, the biggest US firms benefit from earnings in faster-growing emerging markets.

As investors find it more challenging to value companies and to trust both management and markets, they appreciate the value of regular dividends. Furthermore, if markets get ugly, the dividend helps cushion the decline and puts a floor under the stock price—at least as long as the dividend continues to be paid.

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