When reaching for higher yields, don't lose sight of the risks.
With bond coupon rates at historic lows, investment categories that offer alternative sources of yield have been among the most popular over the past couple of years. We see this trend continuing into 2012 and feel that investors should take comfort in the academic evidence supporting dividend investing and the total return approach.
Since 1927, high-dividend-paying stocks have returned 11% per year, beating the 8% return from nonpayers and resulting in an ending wealth that is 8 times larger. Better yet, they accomplished this feat while incurring less volatility. But dividend-paying stocks outperform only over the long haul, so why might 2012 be a particularly good year for dividend-paying stocks? First, stocks offer a better relative value than bonds. Second, large-cap quality stocks are selling at a discount compared with riskier small-cap stocks. Unlike small caps, large caps have the capacity to withstand continued slow economic growth.
Source: Kenneth French
Stocks are reasonably priced relative to bonds. In the four years prior to the start of the financial crisis in October 2007, investors poured $875 billion into stock exchange-traded funds and mutual funds. Stock funds captured 50% of each dollar invested. But in the four years since, investors have avoided stock funds, instead putting 98% of all fund flows into bond funds. That severe risk aversion has led stocks to appear attractive relative to bonds. In fact, the yield differential between the 10-year government bond and the dividend yield on the S&P 500 has not been this attractive since the 1950s. At that time, we were coming out of a period in which the Federal Reserve pegged interest rates at artificially low levels to help the government fund World War II. In the 30 years prior to 1980, the S&P 500 returned 6% per year after inflation compared with negative 2% from long-term government bonds.
Source: Morningstar Analysts
Within stocks, we prefer large-cap and low-risk stocks to smaller-cap or pricier stocks. Economic growth will likely remain subpar, so we want to avoid high beta stocks and those pricing in an expectation for rapid growth. But even with slow growth, dividend-paying stocks should be able to maintain their payouts. Payout ratios are below their historical average, so firms could boost payouts to maintain the dollar amount of payouts. In addition, firms have built a sizable cash buffer, which could be used to increase payments. Companies in the S&P 500 have cash equivalent to $296 per index unit, compared with an index level of 1,250. Net debt per unit has dropped from $1,058 at the end of 2007 to $470 today. In other words, if we enter another recession, companies are much better prepared to handle it.
With that investment thesis in mind, here are some of the funds that we recommend as well as a few high-yielding funds we might avoid.