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Investing Specialists

Dividends: Not Just for Retirees

Income can play a starring role for investors of all ages.

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As the editor of Morningstar DividendInvestor and the manager of its two model portfolios, I tend to speak to an audience roughly double my own age. Given their stage of life, my subscribers understand the appeal of large and steady cash dividends. By contrast, younger folks (from my standpoint, that would be anyone under 60) tend to go for growth, growth, and more growth.

What a shame that is! Dividends are not just for retirees--they're for anyone interested in earning high total returns over long periods of time.

The Bottom Line Is Total Return, Not Growth
Even among investors with a legitimate long-term focus, most seek stocks that can maintain high earnings growth rates for very long periods of time. It's no real mystery why  Google (GOOG) and  Apple (AAPL) get all the glamour, while supposedly slow-growing dividend payers are consigned to retirees and other so-called "unimaginative" shareholders.

Yet again, we find that simple math disputes popular opinion. Capital appreciation is not the sole source of investment returns: Where you can find it, income can be just as or even more important. The combination of capital growth and income is what constitutes total return, and this is what the investor should seek to maximize. Look at it this way: If you can get 10% annual capital appreciation from a stock that pays no dividend, or a 5% yield with 5% annual growth, which will leave you better off? On a pretax basis, the total returns offered by these two stocks are identical. And what if you can find a 6% yield with 6% growth? Return combinations like these and better are not at all rare these days.

Of course, the sharp eyes out there will be quick to note that pretax returns are not the same as what a taxpaying investor earns after the IRS takes its obligatory bite. True enough, but this is often a red herring: For many investors (and probably most), the bulk of their investments are held in tax-deferred accounts such as IRAs and 401(k)s where investment income--capital gains, dividends, whatever--triggers no current tax bill. Withdrawals will be taxed as income when they're made regardless of where the money came from.

I'm happy to grant that minimizing taxes is a laudable goal, but not to the exclusion of all else. Indeed, my portfolios are full of stocks providing yields of 3% and up with annual total return prospects in the 12%-15% range over the long term. Even if I have to pay some taxes along the way, my aftertax capital can still compound at a very attractive rate.

Growth and Reinvestment: Let Us Choose!
Let's tackle another misconception regarding dividends: their role in growth. Businesses that pay out a large proportion of earnings through dividends (let's say any payout ratios over 50%) are often thought to lack growth potential. Who would want to invest in a business that can't grow earnings at double-digit rates? I certainly would--as long as my yield is attractive. When a company pays out a big dividend, it's giving shareholders the opportunity to allocate capital themselves. Low- and no-payout firms withhold this control from their investors.

Not that this is always a bad spot to be in: A well-run enterprise like  Johnson & Johnson (JNJ) can pursue certain high-return business opportunities through reinvestment and bolt-on acquisitions that would be very difficult for me, the small outside investor, to duplicate on my own. J&J has been earning returns on equity north of 25% for a decade now, so letting J&J management take responsibility for a significant share of my "growth investing" is a good choice.

Beyond a certain point, however, incremental growth opportunities should be left for investors to pursue on their own. I can take the dividends I receive from Johnson & Johnson and invest in any of the thousands of other stocks out there--pipelines like  Magellan Midstream Partners (MMP), banks such as  City National (CYN), real estate investment trusts like  Developers Diversified (DDR), maybe even more J&J stock--whatever offers me the highest total return potential. If J&J kept all of its earnings to itself, I wouldn't have this option. The growth of my investment would be 100% tied to the whims of management, and their interests may or may not coincide with mine.

My Personal Portfolio
I'm a big fan of dividends--not just professionally, but personally as well. I like seeing large sums of cash roll into my account balance every quarter, even though I have no plans of spending this cash for decades to come. I like knowing that the businesses I own are generating real cash flow and sharing it directly with owners. And I really enjoy the extra control over capital allocation this strategy provides. I, not some CEO out there, get to decide what the best incremental opportunities for investment are.

This isn't to say that growth through capital appreciation is off my radar. These days, roughly one third of my personal portfolio is dedicated to thinly traded, poorly understood, deeply undervalued micro-cap stocks--a long-standing hobby of mine in which I've had some very good success. But the other two thirds of my portfolio is devoted solely to dividend-paying common stocks. Collectively, they provide a current yield of over 6%--with a particularly large contribution from DividendInvestor recommendation  CapitalSource (CSE).

No, I don't need a big yield on my portfolio to pay my mortgage or the gas bill. But income is not a phenomenon whose appeal should be restricted to the here and now. If these firms continue to grow their dividends the way I expect them to, and the cash flow they pay me in the meantime gives me the opportunity to acquire more dividend-paying shares, I should arrive at retirement with a very handsome income stream. The transition to "portfolio paychecks" will be seamless, and my investments--rather than me--will have done the vast majority of the work.


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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.

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