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The Virtues of Dividends

In today's conditions, high-payout stocks have the ability to offer something cash, money markets, and bonds can't: real return.

Josh Peters, CFA, 10/20/2011

Every time interest rates drop or a recession threatens, dividend investing invariably gains in popularity. I've seen more than a few of these cycles since 2005, when I became the founding editor of Morningstar DividendInvestor newsletter. I've seen even more since my career as a personal investor began with the purchase of eight shares of Minnesota Power & Light (now ALLETE ALE) in 1990. To think that a routine, low-risk utility selection yielded nearly 8% back then!

But we're in no ordinary cycle, and dividends are no mere fad. Long-term investors of nearly all stripes are grappling with a singular problem: how to preserve the purchasing power of our capital and wring some positive returns out of an environment that seems determined to rob savers and risk-averse investors of fair treatment. Exhibit 1 (below) illustrates the challenge; the real return on so-called "risk-free" investments (I use a one-year Treasury bill as a proxy) is now sharply negative. Today, avoiding risk, at least in the usual sense of the word, all but guarantees loss.

Dividend-paying stocks may not be the solution for every aspect of this challenge. For starters, dividends are all but worthless for short-term traders. The best high-yielding stocks in today's environment might yield 6%, but given the volatility to which all stock prices are prone (even dividend payers), a year's worth of dividends could be lost in minutes. High-yielding stocks are also a poor substitute for cash or short-term bonds in an investor's financial safety net. The common stock of AT&T T does yield a lot more than you can get from the bank down the street, but AT&T doesn't guarantee your original principal back the way a certificate of deposit does. And I cringe to think that investors--including a lot of institutions--are climbing aboard the dividend bandwagon with an eye to merely "lose less" than the leading benchmarks.

That being said, we're in an environment where super low returns all but force investors to embrace some kind of risk, which in turn raises the question of which risks are worth taking. For serious long-term investing, high-payout stocks are far better positioned than cash, long-term bonds, and stocks with low or no dividend yield. They may even be the only way to get a decent real return.

A Real Challenge
Although I make a practice of keeping DividendInvestor's model portfolios fully invested (or nearly so), I have a lot of respect for cash. Ordinarily, it won't earn much of a return, but it always trades at par, it comes in handy during a crisis, and, in prudent hands, cash can have extra value by being ready for attractive opportunities that come along. Yet cash is being trashed--and so are all risk-free, near-cash investments, such as money market funds, short-term bonds, and certificates of deposit. In the 12 months through July, consumer price inflation ran at 3.6%. With one-year Treasury bills furnishing a return of only about 0.2%, their holders have suffered a 3.4% loss of purchasing power. Worse, the pace of inflation--at least until very recently--has been accelerating: Earlier this year, inflation was running at an annualized rate of 5% to 6%. By itself, this rate would be cause for some concern, but because interest rates have not risen in tandem with inflation, the purchasing power of cashlike investments is falling at an unusually steep rate.

This situation makes the Federal Reserve's monetary policy statement on Aug. 9 all the more extraordinary. With one hand, the Fed threw the economic recovery under the bus; with the other, it very nearly promised to hold short-term interest rates to near zero for another two years. So, there we have it: no growth, no yield, and rising inflation. It's hard to think of a worse hand that investors could be dealt.

Bill Gross of PIMCO says that this lamentable situation is actually a key objective of U.S. monetary policy. He believes that the Federal Reserve is determined to hold short-term interest rates below the rate of inflation for perhaps 15 or 20 years to come. In his view, relentlessly "picking the pockets" of savers is the only way--short of outright default--that the excessive debts of governments and households can be reduced to more-sustainable levels.

I've been formulating a similar view, but from a different direction. The world is awash in debt, yes, but for every dollar of debt there is also a dollar that someone else is calling an asset. Thirty years of runaway borrowing on almost all levels have created a stupefying sum of paper assets, but the growth of economic income that is available to provide returns on these assets (corporate profits, rents, tax revenues, and so on) has been left in the dust. We now have a massive, global oversupply of paper value chasing insufficient flows of return. Therefore, we shouldn't be surprised that returns on many financial assets have been driven into the ground. Creditors--corporations, households, and governments--all benefit from ultralow financing costs at investors' expense. Virtuous savers compete for scarce returns, while the imprudent borrowers either prosper or get bailed out. Pocket-picking indeed!

Getting Real With Stocks
What is Gross' solution to this mess? At the Morningstar Investment Conference in June, the Bond King advised the audience not to buy bonds, but high-quality, high-yielding stocks instead: Procter & Gamble PG, Coca-Cola KO, electric utilities like Southern SO, and so on. Gross manages the world's largest portfolio of bonds, and he's doing the best he can with that mandate. Many portfolios are forced to own bonds for legal, regulatory, or other reasons, so it's not as though he's putting his day job on the line. But for those of us who can obtain income through high-yielding stocks instead of bonds, he offered a compelling head-to-head matchup. While Treasury bonds offer negative real returns--even far out on the maturity spectrum--the 3% to 5% yields available on high-payout stocks are the real return, given the ability of dividends to rise along with inflation. Gross went on to suggest that there might not be much real dividend growth, nor much real capital gains, but at least their nominal payouts should do a better job staying ahead of inflation than a fixed-income strategy could.

I couldn't have said it better myself. The critical point here is that Gross isn't saying simply "buy stocks." The stock market as a whole is overrated as a hedge against inflation, as anyone who has studied (or lived through) the rampant inflation and recurring bear markets of the 1970s can attest. Between 1966 and 1992, stocks provided no real capital appreciation. Instead, Gross directs investors to look at dividend yields as their primary source of real return. Even dividend growth (though important in nominal terms as an offset to inflation) has run about only 1% a year for the S&P 500 during the past 50 years. So, if dividends are the primary driver of real returns on stocks, it only makes sense to focus on high-quality stocks that provide high current yields.

Here, another characteristic of high-yielding stocks comes in handy. Not only do they deliver large and growing streams of income to offset inflation and provide the shareholder with a real return, but over long time periods, high-yielders also routinely outperform low- and no-yield stocks by a significant margin. While other studies have illustrated the importance of dividends in total return and the persistent long-term outperformance of high-yielding stocks, the data presented in a newly published book, titled The Strategic Dividend Investor, is one of the most compelling.

The book's author, Daniel Peris, is the comanager of Federated Strategic Value Dividend SVAAX--one of the very few mutual funds that combine a genuine focus on high dividend yields with an equal focus on dividend growth and total return. During the past few years, Peris has become a good friend of mine; while we don't necessarily see eye to eye on every single stock, we're definitely kindred spirits when it comes to investing. The Strategic Dividend Investor tells a story very much like the one I scribble out each month in the pages of DividendInvestor, but even I was surprised at some of the new research he presented, part of which is displayed in Exhibit 2.

Given the aid of time--in this case, 10-year rolling time horizons--the outperformance of high-yielding stocks relative to stocks with low or no dividend yield has been both significant (2.9 percentage points a year on average) and remarkably consistent (27 of the 31 10-year periods in the study saw returns on high-yielders beat stocks with low/no yields). Of course, 2.9 percentage points may not sound like a lot, and in any one year, it isn't. But 10 years is plenty of time for compounding to work its magic. The difference between earning, say, 7% a year and 9.9% a year is the difference between $100 turning into $197 versus an ending value of $257. This 2.9-percentage-point return differential, should it recur in future years, would be critical going forward: It could mark the difference between staying ahead of inflation and falling behind.

The Real Deal
The biggest pitfall in owning high-yielding stocks is that no dividend is guaranteed to keep up with inflation. (As we've recently experienced, they're not even guaranteed to be paid at all.) The ability of a company to raise its dividend at least as fast as inflation depends on the economic attributes and management acumen of the business itself. Not just any dividend, not even a big one, stands an equal chance of preserving the purchasing power of the shareholders' paychecks.

This is all too clear from the experience of the late 1960s through the mid-1970s (Exhibit 3). During that period, the per-share dividends paid on the S&P 500 peaked in 1966 in inflation-adjusted terms. In nominal terms, dividends continued to grow, even rising during the dreadful recession of 1973-74.

But this nominal growth failed to keep pace with accelerating inflation, and the real value of S&P 500 dividends had fallen 24% by 1975. Worse, it took 14 more years for the dividends of the index to reach a new peak in real terms.

What we need is not all that complicated: businesses that can raise prices as fast as their costs are rising, so that profits at least hold steady in real terms and dividends can, too. This concept is neatly wrapped up in what we at Morningstar call economic moats: identifiable and sustainable advantages that a business may have relative to its rivals. A moat can take the form of patents, strong brands, natural cost advantages, customer switching costs--anything that boosts profits and is hard for competitors to replicate. Moats serve several aspects of my dividend-investing strategy, such that I won't consider buying shares of a business that doesn't have one. One is the protection a moat provides to profitability during downturns, reducing the risk of a dividend cut. Another is a moat's encouragement of dividend growth, as it suggests that retained earnings stand a good chance of producing high returns on capital. But in today's environment, perhaps the best aspect of a moat is its ability to protect profits from inflation and preserve real returns for shareholders.

The original, pre-breakup AT&T furnishes such an example. Ma Bell was hardly the world's greatest business, but it did possess a near-monopoly on telecom services in the United States--and that definitely qualified as a moat. So, even while AT&T paid out most of its earnings and provided perennial high yields to its shareholders, the growth of AT&T's dividend managed to stick close to the inflation rate. In real terms, AT&T's dividend in 1980 (before divestiture started hampering Ma Bell's flexibility) was the same in real terms as it had been in 1960. The dividend did a great job delivering real returns to shareholders.

The old Ma Bell may not be around anymore, but as we gaze to the future, it seems to me that the companies we at Morningstar believe have wide economic moats--like Procter & Gamble, Abbott Laboratories ABT, Magellan Midstream Partners MMP, and Altria Group MO, to name a few--provide the best shot at earning real returns through above-average and growing dividends (Exhibit 4). They may not light the world afire, but for anyone willing to make a commitment beyond the horizon of today's low interest rates and weak economic growth, the hefty dividends they pay can provide a path through our current mess.


--Josh Peters

Josh Peters, CFA, is an equities strategist with Morningstar and editor of Morningstar DividendInvestor newsletter.

Josh Peters, CFA, is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks, and is author of The Ultimate Dividend Playbook (John Wiley & Sons, 2008). Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor. Click here for a free issue of DividendInvestor.
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