Let's get the bad news out of the way. Dividend-paying stocks have risen just 2.3% in value on average since 2001, according to Wells Fargo. But if you add in the value of the dividend payments, then you're looking at a healthier 26% return. That's about 6% higher than the broader S&P 500 during that period.
Perhaps even more impressive is the fact that dividend-paying stocks are a lot less volatile. The S&P 500 fell by almost 6% in 2011, but dividend payers as a group rose 0.6% and delivered a heftier 3% return when accounting for dividend payments. Even when you consider the stunning snapback in stocks that occurred beginning in March 2009, the divided payers still generated a total return that was 6.4% higher than the broader market. These are truly rain or shine stocks.
Funny thing is, companies aren't catching the trend, as the amount of money they set aside from their earnings for dividends (known as payout ratios) remains quite low. As Wells Fargo noted in a recent report, "companies may only just be beginning to catch on to the fact that investors are keenly interested in dividend paying stocks."
Indeed, a number of companies appear to prefer stock buybacks to dividends: In the just the first few months of 2012, 14 companies have announced plans for stock buybacks in excess of $1 billion. I am personally in favor of stock buybacks when shares are certifiably undervalued, but companies often seem to buy back stock when they are at multi-year highs. Other companies initiate stock buybacks simply to offset extremely generous stock option grants to executives and board members. That's why dividend payments stand out as the surest way to return capital to shareholders.
And those returns are about to get a lot higher. There were 256 dividend hikes in the S&P 500 in 2010, 342 increases in 2011, and if recent trends are any guide, that number should be even higher in 2012. Meanwhile, not a single company in the S&P 500 cut its dividend for the year ahead when the just-finished fourth quarter results were announced.
Yet companies aren't doing enough. The dividend hikes have been too modest, as companies still seek to retain most of their profits, even if they already possess ample levels of cash for a rainy day.
Consider this: Going back to 1945, dividend-paying companies have typically paid out 53% of their income in the form of dividends. That figure has been trending down in the past 20 years, and now sits at a post-war low of 27%. To get back to the long-term average implies that dividends would almost double from current levels -- even before you account for rising profits in the years to come. Looked at another way, the current dividend yield on the S&P 500 is 2.1%, well below the long-term average of 4.5%, implying greater than 100% upside for dividend payments as we revert to the norm.
Looking at one industry in particular, financial services stocks have historically paid out 34% of their income in dividends, though that figure now stands at 22%. That's partially why I'm a big fan of Citigroup (NYSE: C). It's in my $100,000 Real-Money Portfolio partly because I think it might be capable of a $2 dividend within a few years, which works out to be a 5.7% dividend yield based on current prices. Ford (NYSE: F) is another one of my holdings capable of supporting a yield in excess of 5%. Hasbro (NYSE: HAS) is yet another one that could easily support a high-yield, but the toy and game maker prefers stock buybacks.
If companies are not focusing on dividends as much these days, why would they shift gears and start boosting the payout? Because aging baby boomers demand it, and companies can't ignore them.
In just the past 12 months, investors have poured $4.6 billion into the Vanguard Dividend Appreciation Fund (NYSE: VIG), while the SPDR S&P Dividend ETF (NYSE: SDY) has attracted another $3.3 billion. Risk-averse baby boomers are flocking to dividends, while younger investors that can tolerate greater risk primarily focus on share price appreciation. Notably, it's the baby boomers who make up the fastest-growing demographic among investors.
The long-term macro-economic backdrop also explains why dividend investing may be the major theme for the coming decade. The U.S. and European economies increasingly appear set to grow at a very modest pace, hard-pressed to sustain gross domestic product growth in excess of 2.5% to 3% for a number of years. Even that view may be generous. In eras of low economic growth and correspondingly low organic sales growth, companies settle into predictable rhythms where a sufficient level of cash is on hand and much of the income being generated gets returned to shareholders.
Better than bonds
Some would argue that buying the bonds of blue-chip companies is safer than cashing in on their dividends, which can be cut at any time. That's a sound argument if you think the economy is headed for trouble. But in a stable economy, investors are rewarded for the emphasis on slightly riskier dividends. Consider that Merck (NYSE: MRK), Eli Lilly (NYSE: ELY), Verizon (NYSE: VZ), and AT&T (NYSE: T) all sport higher dividend yields than their bond yields, by an average of 75 basis points (or 0.75%). Thanks to the power of compounding, that really adds up. And potential share price appreciation is just gravy on the cake.
Risks to Consider: Rising inflation would lead to much higher bond yields, which would make dividend yields comparatively less attractive.
As my colleague Carla Pasternak recently noted, taxes on dividends may soon go way up. She says it's not a foregone conclusion, and instead just a campaign platform at this point. But if it does happen, then it would be wiser to own dividend-paying stocks in your tax-shielded retirement accounts. Regardless of where they're held, dividend-paying stocks have proven to deliver solid market returns even as they bring less volatility.
Action to Take --> Standard & Poor's focuses on 49 companies in the S&P 500 known as the "Dividend Aristocrats." All of them have maintained or hiked their dividend for at least 25 straight years. Yet more than half of them yield less than 2.5%, which falls into the "why bother" category as far as I'm concerned. Among the higher-yield players among these dividend aristocrats you'll find Leggett & Platt (NYSE: LEG) with a 5% yield, Sysco Corp. (NYSE: SYY) yielding 3.6%, Kimberly Clark (NYSE: KMB) with a 4.1% yield, and Abbott Labs (NYSE: ABT) yielding 3.5%. These are all solid stocks that are likely to see rising dividends in the future and should be considered core holdings in any portfolio.
StreetAuthority LLC owns shares of T, ABT, HAS, F, C, in one or more if its “real money” portfolios.