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The Courage Only Dividends Can Provide

You don't need to despair in down markets.

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Given the strong start we saw to the stock market in early 2007, this has been a surprisingly tough year--especially for income-oriented investors. Some overvalued and/or risky stocks have come down with good cause, but in general, fear and volatility--not value--have been firmly in charge. And nowhere have the beatings been more severe than in the financial-services sector, an area known for high dividend yields.

But has 2007 really been so bad after all? It all depends on what you choose to measure. The holdings of the two model portfolios I manage for income, Dividend Builder and Dividend Harvest, have chalked up 46 dividend increases with not even a single cut. These dividend hikes have grown the combined income of these two portfolios by more than 7%--this in addition to an aggregate yield that should hit 5% for the year. Sure, many of my recommended stocks have seen price declines this year. (With six banks and several other financial stocks in my roster of 29 recommendations, there's no real surprise there.) But as long as my income is safe and continuing to grow, the fundamental value of these accounts is rising, not falling.

Why can I be so pleased with a tough market? My secret is no secret; it's courage--the kind of courage only dividends can provide. Of all the indicators that an investor can anchor upon in pursuit of profits, only dividends provide more than a mere yardstick. Dividends provide cash for investors to use however they see fit--for living expenses, for luxuries, for reinvestment into additional dividend-paying shares. Rising dividends provide evidence that the business paying them is solvent, growing, and committed to rewarding shareholders for the use of their capital. And with income offsetting the need to sell in order for the investor to generate cash, current prices are greatly diminished in importance. I strongly believe this subtle shift of emphasis leads directly toward better investor outcomes.

Developing Courage
The courage to hold stocks through periods of volatility and decline doesn't come out of thin air. For one thing, you've got to be committed to owning stocks for the long term. Shopworn and irrelevant as this advice may seem when prices are falling, it is never more relevant than when the market hits one of its many banana peels. Very, very rarely have I had the pleasure of buying a stock and never again seeing it trade below my purchase price. Quotational losses, even large ones, are all but inevitable; that's part of the trade-off stockholders make to earn good returns over long stretches of time. If investors can't stand to see their paper value drop, they should not own stocks at all--or long-term bonds, for that matter.

Second, you've got to know what you own. Virtually all of the financial stocks I follow have been shellacked this year; panic always throws the babies out with the bathwater. Yet there are huge differences between well-run banks such as  Wells Fargo (WFC) and the bucket-shop mortgage lenders like  NovaStar (NFI). Wells exercises discretion and caution before making loans, and it funds itself with solid, low-cost deposits. NovaStar flunks on all of these counts. By virtue of these distinct fundamentals, stocks like Wells Fargo can be held through turbulent stretches with confidence; the NovaStars of the world cannot.

These first two points are well heeded by all investors, not just those who own stocks for income. Yet it can still be very hard to summon the courage to hold when market price is the primary reference point for investment success or failure. A stock that rises day after day means the investor has made a good choice, while a falling price suggests failure and loss. Investors who anchor their strategies solely on stock prices are doomed toward despair in markets like these.

Dividends: The Ultimate Source of Courage
It's often said that "price is what you pay, but value is what you get." Here is where dividends come in very handy: These payments are, for most stocks, the ultimate source of value. When I buy a stock, I ask first if its dividend is safe: Can I rely on this dividend through a wide variety of business conditions? Assuming the dividend is reliable, I proceed to estimate how fast the dividend will grow: A rising stream of cash confirms the wisdom of an investment in a way short-term market prices never can. If this combination of income and growth stands to provide me with a satisfactory return, I shouldn't have to sell. And once I've bought a stock, I use these same metrics--income and income growth--to measure my progress. This gives me the courage necessary to withstand the inevitable bouts of volatility and short-term decline.

Case in point:  BB&T Corporation (BBT), a super-regional bank headquartered in North Carolina. I first recommended BB&T in January when it traded around $42 per share and provided a dividend yield of 4%. I checked the dividend history, examined the books, ran the numbers, and concluded that BB&T's dividend was not only reliable but likely to grow at an 8% average pace for many years to come.

It almost goes without saying that BB&T shares have since been caught up in the widespread dumping of financial shares. I'm sure other investors are washing out, taking big losses. But I don't look to the stock price as an indication of value; that's what I use dividends for. Earlier this year, BB&T raised its dividend rate by 10%. As the economy softens and the capital markets churn, my quarterly cash dividends show up on time with no declines. The only factor that has really changed is the price: Between that dividend hike and 20% drop in the stock price, BB&T now offers a handsome dividend yield of 5.6%. As long as this dividend is safe and continues to grow, my cash returns provide more than enough incentive to hang on. And when other investors move beyond the fog of current panic to see value more clearly, I have every reason to believe BB&T's market price will rebound sharply.

Such is the magic of dividends: They provide an objective measure of value that does not depend on the fickle opinions of others. And not only is this measure objective, it puts cash in my pocket!

Putting Dividend Courage to Work
This may seem obvious, but it can't be said enough: Dividends are always and only a positive contributor to investor returns. Not only do dividends provide income, but they offer key insights into future returns as well as independence from short-term market judgments. My newsletter, Morningstar DividendInvestor, is devoted to putting these three "I's" to work with real money. With so many attractive dividend-paying stocks available these days--the best of which I seek to recommend in DividendInvestor--I encourage you to give my unique, dividend-centric approach to investing a look.

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Josh Peters, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.