A dividend investing strategy is a smart way to generate income and total return, as history has shown. Dividend-paying stocks have outperformed non-dividend payers over time; since 1990, consistent dividend payers, as represented by the S&P 500 Dividend Aristocrats, earned an annualized 11.04% total return, while the broader S&P 500 index earned only 8.23%.1 In low-rate, low-growth environments, this outperformance is often even more pronounced. For the year ended December 31, 2011, dividend payers of the S&P 500 had an average total return of 1.4% vs. -7.6% for non-dividend payers.2
But dividend-paying stocks could come under pressure this year as a result of several factors. According to Standard & Poor’s, if the domestic economy continues to pick up steam, investors are likely to shift assets from defensive into more cyclical sectors in what is known as sector rotation. Defensive sectors, such as Telecom Services, Utilities and Consumer Staples, have offered the highest yields, while cyclical sectors, such as Consumer Durables and Technology, have offered lower yields.
Another source of potential pressure is the concern that taxes on dividend income may rise. Under current law, the federal tax rate on qualified dividends will increase from 15% to 20% on January 1, 2013. What’s more, under the budget proposal submitted by the Obama administration, dividend income would be taxed at the much higher earned income rate for households making more than $250,000 annually ($200,000 for single filers). Such increases could reduce the appeal of dividend-paying stocks as investments for income-oriented investors. Even if Congress extends current rates and rejects the administration’s budget proposal, the uncertainty of dividend tax rates could put pressure on dividend-paying stocks.
Given this environment, dividend investors should view dividend-paying stocks as a multiyear play. Dividend payout ratios, currently near historic lows, will likely rise over time as today’s cash-rich companies see increasing pressure to share the wealth. Long-term demand for dividend-paying stocks should also be boosted by the wave of baby-boomers entering retirement over the next two decades, many of whom will be seeking income-paying alternatives to low-yielding bonds.
Other strategies to consider:
Look for high-quality issues with an established history of dividend payment and annual increases. Such companies are represented by the S&P 500® Dividend Aristocrats index, which measures the performance of large-cap, blue-chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years. As noted above, this index has outperformed the broader S&P 500 Index since its inception in 1990. These long-term dividend payers have a proven track record and are more likely to continue paying dividends. Many are also sitting on record amounts of cash.1
Diversify Sectors Defensive sectors such as Telecom Services, Utilities and Consumer Staples are likely to still offer the highest average yields. But if the US economy continues to improve, they may see erosion in prices. By diversifying, investors may be able to offset potential price losses with gains in sectors that are better positioned to benefit from an expanding economy.
Consider Euro Zone stocks, which may offer higher yields in the current environment. While the US economy has made strides in recent months, the Euro Zone remains mired in recession. A more defensive stance in Euro stocks is warranted, which favors dividend-paying sectors. Keep in mind, however, that higher yields, especially abnormally high yields, can be a warning flag that a company is not in good standing and has fallen out of favor with investors for any number of reasons.
At Morgan Stanley Smith Barney, we track thousands of dividend-paying companies. Contact me so we can tailor a dividend strategy that suits your specific needs.
1 Source: Standard & Poor’s. For the 22 years ended December 31, 2011. Dividend Aristocrats consists of stocks within the S&P 500 that have increased their dividend payment in each of the past 25 years.
2 Source: Standard & Poor’s. Based on equal-weight indexes of all dividend-paying and non-dividend-paying stocks within the S&P 500.
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Bruce Hemmings is a Senior Vice President – Wealth Management and Financial Advisor at Morgan Stanley at Centerra. He can be reached at email@example.com or (970) 776-5501.
The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates.