Last Updated Feb 17, 2011 4:08 PM EST
With income so hard to come by, why are investors turning their noses up at dividend stocks?
For nearly two years, money has flowed into assets that are polar opposites: At one end of the spectrum, investors have been attracted to small company stocks and tech stocks, which offer the prospect of high capital appreciation as long as we experience robust economic growth. At the other end, bonds provide regular income and investors have snapped them up as protection against continued economic sluggishness, or worse.
But why settle for either/or when you can have both growth and income? Financially strong blue-chip companies offer consistent earnings growth, and their reasonably priced shares are pay hefty dividend yields.
“Dividend stocks seem to be some of the most compelling buys around,” said Hans Olsen, chief investment officer of J.P. Morgan’s Private Wealth Management business. “I think what you’re seeing is people falling out of love with equities right now and the uncertainty that investors have with the type of environment we’re in. Despite strong corporate profits and strong balance sheets, people seem to have turned their backs on equities [in favor of] what they think is a sure return in bonds.”
If they turned back around, they would find companies, including many multinational titans with household names, that are so cheap and pay out so much in dividends that their stocks yield more than their bonds. (Normally, bonds have higher yields than stocks.)
The research firm Morningstar assembled a list of 29 such companies. Nearly half are utilities such as Exelon (EXC), Dominion Resources (DOM) and Consolidated Edison (ED), the sort typically associated with high dividends. The rest read like a Who’s Who of corporate America, with top-notch representatives of a wide variety of industries, including health care — Abbott Laboratories (ABT), Johnson & Johnson (JNJ), Merck (MRK) — consumer staples — Clorox (CLX), Kimberly-Clark (KMB), Philip Morris International (PM) — energy — Chevron (CVX) and Conoco Phillips (COP) — and telecommunications — AT&T (T) and Verizon (VZ).
In calculating yields, Morningstar used analysts’ estimates of dividends to be paid over the next four quarters rather than historic dividends. That eliminated down-and-outers that have experienced plunging share prices and slashed dividends, artificially inflating current yields. As for bonds, Morningstar used the yield to maturity of issues that come due in about 10 years.
MoneyWatch Picks: Big Companies, Big DividendsSource: Morningstar
Low Risk, High Reward
We’re not suggesting that you compile a list of stocks based on any simple criteria and put in wholesale buy orders. Nevertheless, investment advisors give this group of high-income blue chips very favorable reviews. Based on their recommendations and other criteria, we whittled the list down to a Top 10 that could form the backbone of your income-oriented stock portfolio.
A dividend-paying stock offers a considerably greater risk/reward proposition than a bond of the same company that has the same yield, let alone a lower-yielding bond, according to fund managers who focus on income. They concede one key point in favor of bonds — regular coupon payments are virtually assured, while there is always the prospect that a company will cut its dividend— but they say these blue chips are far more likely to boost their dividends than reduce them.
“Large multinational companies have a good record of regular dividend growth,” says Ed Perks, manager of the Franklin Income Fund, which holds four stocks on the Morningstar list: J&J, Chevron, Conoco and Dominion. “It’s not just a hope and a prayer that they’ll increase them. Over a long period of time and different economic environments, there’s a commitment to increasing dividends to shareholders.”
Honoring that commitment should be a snap for companies like these because they have very low payout ratios, or the proportion of earnings disbursed as dividends, says Mark Freeman, manager of the WHG Income Opportunity Fund. Freeman owns J&J and Chevron, along with Philip Morris, AT&T, the utilities PG&E (PCG) and American Electric Power (AEP), the drug maker Bristol-Myers Squibb (BMY) and Sysco (SYY), a food distributor.
Dividend investors don’t need a miracle to do well. Freeman points out that companies that maintain a stable payout ratio will increase their dividends by an amount equal to the increase in their earnings. And if their valuations stay the same, their share prices will rise in line with earnings, giving shareholders two sources of returns. Investors who prefer bonds to stocks with similar yields are giving up future earnings growth for the guarantees offered to bondholders.
“They’re willing to forego any upside and accept this very low nominal yield in exchange for the certainty that they’ll get their money back,” Freeman said. “What I don’t think they realize is when you do that, you’re effectively taxing yourself” by giving up the growth to which bondholders aren’t entitled.
The added tax burden isn’t just a figure of speech. Bond income is taxed at the same rate as ordinary income, while dividends have been taxed at much lower rates for most of the last decade. Congress has yet to decide whether to maintain the discrepancy, which is due to expire at the end of 2010, but a lower rate on dividends is widely expected to continue for investors earning less than $200,000 a year.
Why are investors willing to pay so much for the extra certainty offered by bonds, and why are they unwilling to pay up for high-income stocks? “It’s just a symptom of this world we’re in where confidence is low,” says Gus Zinn, co-manager of the Ivy Core Equity Fund.
But that’s the sort of world in which dividends could matter most. Compounded dividends for many decades have accounted for nearly half of the returns of stocks. Between 1926 and 2009 stocks returned 9.6 percent a year, on average. Take out the dividend income and the return falls to 5.5 percent. In the boom times of the 1990s, investors didn’t care about dividends — who needed a 3 or 4 percent payout when tech stocks were doubling and then doubling again— but with economic conditions and investor sentiment subdued, Freeman predicts that “we’re probably going back to markets where the dividend portion of returns is a big deal.”
The Dividend Achievers
Stocks on the Morningstar list that he likes include AT&T; Conoco, which he said could increase its dividend by 15 percent a year; Philip Morris, for its “great emerging market exposure,” and Sysco.
So which stocks should comprise your high-income Top 10? Based on portfolio manager preference, a desire for diversification, market value (bigger is better), the gap between stock and bond yields (bigger is better here too) and valuation (small is better on this one), here they are: AT&T, Bristol-Myers, Chevron, Conoco, Dominion, Exelon, Kimberly-Clark, J&J, Philip Morris, and Sysco.
The 10 stocks represent seven industries. They have an average dividend yield of 4.4 percent, more than twice the yield of the broad market, and their average price/earnings ratio is 11.4, lower than the market average.
“In a world of lower long-term return expectations,” says Perks, “if you find investments where you have a 3 to 4 percent dividend yield, plus prospects of 4 to 5 percent annual growth and attractive valuation levels relative to long-term historical ranges, there’s a pretty powerful argument at least for putting part of your investment mix into stocks like that.”
More on MoneyWatch: