Why Own Stocks in a Recession? Dividends!

From the looks of recent trading in the stock market, nobody is waiting around for the authorities at the National Bureau of Economic Research to formally declare the U.S. economy in recession. Amid record price volatility, investors are now turning over their portfolios to leave cyclical sectors and seek "safe havens" in recession-resistant industries.

As editor of Morningstar DividendInvestor and manager of its two income-generating model portfolios, I haven't had this problem. I discovered--to my delight--that my pursuit of dividends is yielding (if you'll pardon the pun!) a very nice side effect: I didn't own deeply cyclical stocks in the first place, for the simple reason that they're not very good at paying reliable dividends.

There's Always a Recession Coming!
I'm something of an armchair economist, and I find it both interesting and useful to think about the ways that major economic institutions interact with one another. And, like many observers, I've been worried about the major structural imbalances (asset bubbles, trade deficits, negative household savings rates) that have been plaguing the U.S. economy for a decade now.

I have to be honest: I didn't see this particular recession coming. But that's not the point. I don't let near-term economic forecasts interfere with my investment choices. As legendary investor Peter Lynch once said, "If you spend ten minutes a year thinking about the economy, you'll waste seven minutes." There are always things to worry about, yet somehow the economy continues to function. If I were to take my armchair prognostications seriously, I'd probably fake myself out--and miss out on the solid income, income growth, and long-run capital appreciation that well-chosen, dividend-paying stocks can provide.

So rather than trying to guess at the next turn in GDP or employment, I invest at all times as if there's a recession right around the corner. Predicting a recession is like forecasting rain: Given enough time, both are bound to happen. Yet if I can find stocks that I would be willing to own through a recession--specifically, stocks that can maintain and even raise their dividends through a downturn--I can buy and hold them with confidence.

Investing in the Essentials
Which companies pass the test? The candidates are pretty obvious: utilities, pipelines, food and beverage manufacturers, health-care firms and the like. These are all essential goods and services; they're not needed to grow the economy, but just to keep consumers and businesses where they're at today.

These businesses are not necessarily recession-proof, because a downturn has a way of draining marginal purchasing power from consumers and businesses across the board. Even utilities may not be completely immune, since cash-strapped households can always dim the lights (though variances from industrial and commercial customers are a more significant swing factor). But economic influences on revenues and earnings are generally modest; cash flows tend not to change dramatically in response to a boom or a bust. Investors don't find companies like  Kraft Foods (KFT) or  AGL Resources  all that attractive when the economy is expanding rapidly, but they can't help but look good in times like these.

What I like about these companies is not just that their financial results tend to be steady, but that so many of them devote large chunks of their earnings to dividends. This might go without saying, but I'll say it anyway: A cash dividend is an investment return that is positive 100% of the time. This return is independent of the stock price; in fact, those buying stocks at today's low prices are finding better dividend yields than have been available for years. Dividends, too, look pretty boring when prices are shooting up. I can understand why so many investors abandoned dividend-paying stocks in the late 1990s: What good is a 2% or 3% or 6% yield when stock prices are doubling and tripling? But in the bear markets--and this one is no exception--boring old dividends start to look pretty good.

Of course, volatility in earnings and cash flows, especially when exacerbated by financial leverage, are not the dividend collector's friend. I figure I can afford to tolerate a lot of volatility in share prices (as if I had a choice!) as long as my dividends remain safe. But if a dividend stands to be cut during any downturn, all bets are off. This explains why I've stayed away from businesses that are inherently unstable, whether it's a matter of commodity prices ( Southern Copper  or  Pengrowth Energy ), discretionary consumer and business spending ( General Motors (GM)), or industrial cyclicality ( Xerium Technologies ). I could have bought any of these stocks in the past few years for what appeared to be hefty dividend yields, but by now I wouldn't have been at all pleased with the results.

When to Make Exceptions: Margins of Safety
The only exception I've made to this recession-resistant approach is when I can find a large margin of safety for my income heading into this downturn. Case in point, I've owned quite a few bank stocks over the past few years. I knew bank earnings could and almost certainly would decline in a recession, and that they have. But in buying high-quality, prudent lenders like  BB&T (BBT) with payout ratios of 40%-60% in normal times, I had lots of room for profits to fall amid higher loan losses before profits would fall short of dividend payments. And though my choices among banks haven't been perfect (having suffered one painful dividend cut while dodging a few others), my bank holdings as a group continue to generate both hefty income and continued dividend growth for my portfolios.

And while I expect to stay invested largely in economic essentials through boom and bust, I can't help but turn a hungry eye toward a few exceptionally strong cyclicals like  Caterpillar (CAT),  Eaton (ETN), and  PACCAR (PCAR). These stocks offered only pedestrian 1%-2% yields when their stock prices peaked, but their balance sheets are strong, their payout ratios leave plenty of room for cyclical declines in earnings, and plunging stock prices have created juicy 3%-5% yields for today's bargain-hunters. I'll be the first to admit that I don't know how to time a bottom for these stocks, but yields like these are offering investors handsome compensation to be early.

Opportunities Abound
One of the outstanding features of the market's decline since mid-September has been that just about everything has been tossed into the trash, whether it was overpriced, cyclical, leveraged or not. I guess when investors can't sell what they want to sell, they sell what they can. But in their selling, lots of bargains have been created--including quite a few among companies where the risk of a dividend cut is decidedly low. I need look no further than my 34 DividendInvestor portfolio holdings, which recently yielded a handsome 6% on average.

My holdings have lost value this year (though much less than the market in general), and I can't guarantee that all of my dividends won't be cut. Still, my investment process since January 2005 has produced 133 separate dividend increases and just two cuts. So in a market that can seem unhinged from underlying business reality, my dividends give me the confidence to continue holding stocks through a recession and beyond. 

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