Even though the yield on Treasuries is at historically low levels, investors are willing to sacrifice the returns they need for the sense of security they want. Unfortunately, this fixation with ‘safe’ assets doesn’t make much sense within the context of long-term goals.

Let us now look at the other side of the Treasuries phenomenon. In their quest for certainty, many investors may be unwittingly ignoring dividend yields on stocks, which have become more compelling as a result of the downturn in global markets.

The Dividend Yield

As dividend investors, we have recently noticed that the dividend yield on the S&P 500 Index is greater than the yield on U.S. Treasury bonds for the first time in 50 years!

Case in point, the dividend yield on the S&P 500 as of the end of November was about 3% versus the yield on the 10-year Treasury which today, is about 2% (the 2-year Treasury is yielding about 0.70%). What’s more, this isn’t just a U.S. phenomenon. In Europe, the yield on stocks also currently exceeds the yield on government bonds.

Of course, dividends are a key part of total returns (price appreciation plus investment income, including dividends).  The fact that dividend yields are high relative to Treasury yields right now makes the case for dividend-paying companies that much more compelling.  

If we look back to the period between 1974 and 1982, the performance of the S&P 500 was sluggish on a price return basis.  But if you look at what happened as markets began to recover, including dividends in the returns that investors earned as they emerged from a period of economic uncertainty and capital market weakness (i.e. looking at total return) made a significant difference.

Herding To Safety

Today, the desire for safety runs the risk of driving ‘the herd’ off the edge of the proverbial cliff as people abandon their long-term goals in favor of short-term stability. But despite what the headlines might suggest, the world isn’t two- dimensional.

That is to say it’s not just risky assets or safe assets. To see the total picture, including why dividends need to be a key consideration in the investment process, is a starting point to having better, more robust conversations in today’s uncertain environment.

Black Friday

Black Friday is so named because it’s the day that retailers finally move into “the black” for the year and it’s the day that marks the unofficial beginning of Holiday shopping. It’s also the busiest day of the year for most retailers in the U.S. and a day that many items go on sale as businesses compete for those gift shopping dollars. Seasoned shoppers will do their research by scouring through local papers then line-up early in order to get the best deals – after all, if you can get the same item at a lower price, why wouldn’t you?

Strangely, when it comes to investing it seems that people want to pay more. Mutual fund sales show this time and time again. When markets are close to their peaks, mutual fund sales are strong, but when markets are close to their bottoms, mutual fund sales are weak. But who can blame investors? If we look at markets in the U.S., the S&P 500 Index is currently at levels similar to 10 years ago and while Canadian markets have faired somewhat better, it’s still been an ugly 10 years.

A Lesson In History

In 1974 the S&P 500 Index dropped from a closing value of 99.74 on March 13 down to a closing value of 62.28 on October 3 losing over 37% of its value (note that the index is based on price only and does not include dividends). And much like today, there were several events that were weighing on the minds of investors, such as:

1. The energy crisis following the OPEC oil embargo
2. The resignation of President Richard Nixon following the Watergate scandal
3. The loss of Vietnam war
4. An economy in recession

What investor would want to be in the market at a time like that?

Well, as it turns out, a very astute one. The table below shows the returns of the S&P 500 Index following October 1, 1974.

S&P 500 Index

The most important thing an investor can do right now is to learn from history. Although there are some differences between any two periods of time, there are examples of times in the past with many similarities to what we are seeing today.

Those past times represented outstanding investment opportunities in equity markets. No one knows exactly when the market will be at its bottom, but if you’re buying right now, you know for fact that it’s not at its peak. And, like many consumer goods, the market is on sale.

Inflation Control

The central bank fights inflation by attempting to control the rate of growth of the money supply. When inflation is rampant, interest rates will rise, as the central bank attempts to cool down the economy. The bank will attempt to decrease the supply of money available in the banking system, thereby causing demand in the economy to contract.

If this is done, the result will be a decline in the rate of inflation and a relative decline in the demand for money. If the economy shows signs of recession, the central bank will supply more money to the banking system and expansion will usually follow. Interest rates will decline for the short term even though the injection of more money into the economy is inflationary in the long run. A catch 22.

Use The Fed To Buy Fixed Income

Since fixed-income security prices move contrary to interest rates, the best time to invest in fixed-income securities is at the peak of an inflation cycle, when interest rates are high and fixed-income securities trade at low prices.

Such opportunities are likely to occur periodically every few years, due to the inability of federal governments to fight inflation with only fiscal policy and the limitations that the central banks face when trying to curb inflation with tight monetary policy.

That said, just how an investor determines when the peak in the cycle occurs is a question that is not easy to answer.

How Are Common Stocks Affected?

The reaction of common stock yields to fluctuations in interest rates, both nominal and real, is very similar to that of fixed-income security prices, and that similarity is quite natural. Regardless of whether an investment is made in common stocks or fixed income securities, the expected result is a satisfactory rate of return.

The typical measurement for common stock returns is the return available from short-term bonds or the risk free rate. When returns from fixed-income securities are low, the stock market becomes more attractive, since even common stocks with relatively low dividend yields provide a competitive alternative to fixed income securities.

On the other hand, at the peak of an inflation cycle, stock prices are very high. Their returns and yields compare unfavorably with the high yields available from fixed-income securities and there is less risk of loss of principal from fixed-income securities.

What Happens When It All Hits The Fan?

Sensitivity of the stock market to fluctuations in interest rates has been particularly pronounced in the last couple of decades – however, in the recent crisis this correlation has been all but thrown out the window!

Knowing this, where do we stand in this cycle today?

What does this mean for stock prices in the near term?  The long term?

When starting your research for dividend growth stocks, much of the work has already been done for us.  We just need to know where to find it!

Start out by reviewing the Dividend Aristocrats or Dividend Achievers lists to identify a broad category of stocks that have consistent dividend growth.

Once you have identified a list of stocks using the dividend achievers list, it is time to narrow it down to a few of the best dividend growth stocks.

Sector Selection

A general rule of thumb for dividend growth investors is to select one or two stocks in different sectors, such as insurance, utilities, financials, telecom, etc., with the higher than average dividend yield and a recent dividend increase.

Many dividend growth investors will require that the dividend increase be within the past year, the more recent the better. Dividend growth investors are of the philosophy that an increase in a company’s dividend means that the company is healthy and its future prospects are solid. Therefore, the amount that the dividend is increased should also be taken into consideration.

Dividend Growth Rate

The amount that a dividend is increased on a year to year basis is called the dividend growth rate. The philosophy of dividend investors is that the higher the dividend growth rate, the higher the prospect for the stock to increase in value.

For instance, Sun Life Financial (SLF) has a dividend growth rate of approximately 20% over the past 5 years. Over that same time, the stock has doubled in value from $20.00 per share to over $40.00 per share. If you had purchased Sun Life Financial 5 years ago at $20.00 per share, with the current dividend rate of $1.07, your yield on the purchase price would be 5.4%.

Not only would one be receiving these healthy dividends this year, but one could reasonably expect to get a 20% raise next year!

This is the basis of dividend growth investing; to produce consistent and inflation hedged income.

Due to the fact that the dividend growth rate can play such a significant factor in the future value and income potential of the stock, it is suggested that the investor find a middle ground when choosing stocks for a dividend growth portfolio.

The middle ground should consist of:
1.) A reasonable current yield, compared to its peers and itself historically.
2.) A recent dividend increase combined with increased earnings
3.) A high dividend growth rate compared to the industry.

Stocks selected from Mergent’s Dividend Achievers that display these factors should provide a great starting point to a dividend growth portfolio.

With the recent turmoil in the markets, now is an especially great time to search for financial services companies and banks that have strong balance sheets and are well capitalized.  Consumer staples and health care stocks are also viewed as potential safe havens and opportunity stocks in this type of market.

I’d be happy to hear any comments or questions regarding this strategy and I hope to have more detailed information up here in the near future.

I am a huge proponent of buying the best dividend paying stocks when they are value priced. However, if you aren’t sure about picking an individual stock and you still want to reap the rewards of Dividends, check out this list of some different Dividend Exchange Traded Funds (ETF’s).

The Vanguard Dividend Appreciation Fund (AMEX: VIG) is a one of the cheapest dividend ETFs, with an expense ratio of 0.26%. Some rivals charge as much as 0.60%. But fees aren’t everything here. VIG’s current yield — slightly less than 1.77% — is on the low side, as is its total return of roughly 7% since its inception in late April 2006.

VIG is benchmarked to the Mergent Dividend Achievers Select Index, a subset of the Mergent Dividend Achievers Index — a market-cap-weighted index of stocks with a consistent history of increasing dividends. Its holdings are highly concentrated in three sectors: consumer staples at 23%, financials at 20%, and industrials at 17% of assets. The top five stock holdings include Johnson & Johnson, GE, ExxonMobil, AIG, and IBM, each representing roughly 4% of assets.

Among other ETFs focusing on high-yielding equities, the iShares Dow Jones Select Dividend (NYSE: DVY), the first dividend ETF, has gathered more than $7 billion in assets. It invests in 100 of the highest dividend-yielding securities (excluding real estate investment trusts) in the Dow Jones U.S. Total Market Index.

First Trust Morningstar Dividend Leaders (AMEX: FDL) invests in the top 100 stocks of the Morningstar Dividend Leaders Index. These are the index’s highest-yielding stocks, ranked by the consistency with which they pay dividends and the ability to sustain those dividends going forward. Three securities — Citigroup, Bank of America, and Altria — together make up more than one-fourth of the fund.

State Street SPDR Dividend (AMEX: SDY) invests in the 50 highest dividend-yielding S&P Composite 1500 constituents. This index tracks equities that have consistently increased dividends every year for at least 25 years. Investing in these long-term dividend-paying stocks reduces the risk that the fund’s holdings will cut their dividends.

For Dividend Daredevils
More adventurous investors might consider the Claymore/Zacks Yield Hog ETF (AMEX: CVY), which aims to double the yield of other dividend-paying ETFs. The fund invests in high-yield securities such as preferred shares, master limited partnerships, closed-end funds, American Depository Receipts, and Real Estate Investment Trusts. It’s a riskier play, since the holdings don’t all have a long history of regular, stable dividends.

Paying the piper
Tax law changes in 2003 lowered the tax on most dividends to 15%, making dividend-paying stocks more appealing. This law is set to expire at the end of 2008, and if it does, dividend-paying stocks may become less desirable.

Courtesy of Motley Fool