Don't Drop Your Dividend Stocks

07/03/2013 6:30 am EST

Focus: STOCKS

David Dittman

Chief Investment Strategist, Australian Edge, Canadian Edge, & Utility Forecaster

History has proven that sticking with dividend payers through good times and bad greatly adds to your returns, says David Dittman of Personal Finance.

Dividend-paying stocks have recently been dragged through the mire, sliding steeply after a strong rally, due to rising speculation that the US Federal Reserve will curtail its program of "quantitative easing" and thus unleash interest rates for what's sure to be—at least in many investors' minds—a straight-up climb from here.

The crux of the concern is that dividend-paying stocks' relative attractiveness compared to risk-free assets such as US Treasury bills, notes, and bonds will disappear, as the latter's rate of return goes higher and closer to historic norms.

Traditional bond buyers who were driven into equities because risk-free vehicles were yielding less—or at best only slightly more—than the rate of inflation, will likely herd back into Treasuries now that market rates may no longer be compressed by the actions of an interventionist Fed.

But the recent sell-off presents an opportunity to establish positions in essential-service companies, master limited partnerships, and select, high-dividend-paying Canadian stocks, as many of our favorites have traded above our recommended buy-under targets.

You can take comfort that, historically, dividend-paying stocks have outperformed non-dividend-paying stocks. According to research compiled in a May 2013 white paper by Goldman Sachs Asset Management, since 1926 dividends accounted for more than 40% of the return of the S&P 500.

From 2000 to 2009, the S&P 500's total return of negative 9% would have been a heftier negative 24% had it not been for the 15% contribution from dividends.

Numbers crunched by Ned Davis Research show that $100 invested in a market capitalization-weighted collection of "dividend growers and initiators" would have grown to $4,169 by December 2012. The same amount invested in the broader group that includes all dividend-paying stocks would have grown to $3,104.

And $100 invested in January 1972 in the S&P 500 Total Return Index on a market cap-weighted basis would have yielded just $1,622 by December 2012.

Dividend-paying stocks have outperformed non-dividend paying stocks on a total return basis. And they've done so with less volatility. Companies that have been able to raise or to begin paying dividends had even higher total returns and lower volatility than the broader dividend-paying group.

Dividend growers and initiators generated a long-term annual total return of 9.55% from January 1972 through December 2012, with long-term volatility of 16.23% and a long-term Sharpe Ratio of 0.32.

(Ned Davis Research defines "volatility" as a statistical measure of the dispersion of returns for a given security or market index. The higher a security's volatility, the riskier it is. "Sharpe Ratio" is a measure of the return achieved for risk taken. The greater a portfolio's Sharpe Ratio, the better its risk-adjusted performance has been.)

All dividend-paying stocks have generated a long-term annual total return of 8.76%, with volatility of 17.03% and a Sharpe Ratio of 0.26. The S&P 500 Total Return Index' annual total return for the comparable period is 7.05%; its volatility is 17.99%; and its long-term Sharpe Ratio is 0.14.

Ned Davis Research also reported that since 1972, dividend growers have significantly outperformed non-payers in moderate, elevated, and most notably, in high inflation environments.

Rising interest rates often follow inflation. And, crucially in this context of fevered worry, dividend growers have historically enjoyed a strong track record as interest rates rise. With less volatility than non-payers, dividend-paying stocks have outperformed over each of the last seven interest-rate tightening cycles.

Even should the economy pick up more speed, employment return to more normal levels, and inflation tick up, high levels of corporate cash on balance sheets and low current payout ratios provide scope for dividend growth.

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