The U.S. economy entered positive territory and stocks rebounded in 2009—but with unemployment at 10%, 2010 will be very much a ‘what-ifs economy’ and an important year for investors to see improvements—a state of affairs that could bode well for dividend-paying stocks this year and into the near future.
The lure of dividends
Before we explain why 2010 could be a good year for dividend-paying stocks, let’s review the lure of dividends in general.
There are two ways stocks can increase in value: by increasing in price or by generating income, which is paid in the form of dividends.
Price appreciation is easy to understand, but many of today’s investors have difficulty grasping the appeal of dividends. But dividends can significantly increase your total return potential. Why? Because many companies offer a dividend payout ratio—a percentage of the stock price. That means that if the company’s stock price appreciates, your dividend could grow exponentially.
According to Investopedia, “This is what Johnson & Johnson did every year for 38 years between 1966 and 2008. If you had bought the stock in the early 1970s, the dividend yield that you would have earned between then and now on your initial shares would’ve grown approximately 12% annually. By 2004, your earnings from dividends alone would have given a 48% annual return on your initial shares!
Stock appreciation or dividends?
Still, because of the potential dividends offer, many decades ago investors owned stocks primarily for their dividends. If the stock appreciated in price, that was an added incentive, but it certainly wasn’t the goal.
In the past decade, however, aggressive investors began to focus more on price appreciation, high growth and high price to earnings multiples—a strategy that backfired during market corrections, such as the dot-com crash of 2000 and the financial crisis of 2008.
Some analysts feel that rapid stock price appreciation in 2010 may be unrealistic. After all, the markets have already rallied significantly, with the S&P 500 Index gaining 26.46% in 2009.1 And much of that gain was driven by indiscriminate investing in low-quality stocks, like the financials. As a result, investors would be wise to consider the total return possibilities of dividend paying stocks. And if the markets do continue to rally, all the better!
I personally believe the market has a good chance of rallying further. Final 2009 S&P 500 earnings are estimated to be between $56 and $58. That would translate into a P/E ratio of about 19 for the index, based on the 12/31/09 close. But the market typically prices stocks based on forward earnings. S&P 500 2010 earnings estimates are running at about $74, and 2011 at about $84. Since the average P/E ratio for the S&P during the last 30 years has been about 18, I could argue the S&P 500 has a shot at reaching 1500 sometime over the next few years.
The dividend outlook for 2010
A dividend strategy may, on the surface, seem like a boring idea right now. That’s because in 2009, companies in the S&P 500 Index slashed their dividends by $52.6 billion, or 21%, according to Standard & Poor’s estimates. On a percentage basis, that made 2009 the worst year for dividend cuts since 1938, when companies slashed their dividends by 39%.
But those cuts may actually be one reason to consider investing in dividend-paying stocks in 2010. Companies slashed their dividends so furiously in 2009, the cuts may be nearly over, according to Howard Silverblatt of Standard & Poor’s.
That’s especially true given the recovering economy. With economic activity improving, Standard & Poor’s is forecasting that S&P 500 Index companies will increase their earnings by nearly 35% in 2010—and as earnings increase, profits could improve, and companies may be able to afford to boost their dividends. Indeed, Standard & Poor’s estimates that S&P 500 companies could increase their dividends 6.1% in 2010.
Moreover, despite the 2009 dividend cuts, dividend yields are still well above many corporate and government bond yields, according to DataStream as of December 2009.
I believe that dividend-paying stocks could attract investors who want to move out of cash and bonds, but don’t want to invest in the riskier stocks that drove the market rally in 2009—which could also boost money flows into this asset class. We are busier than I can remember building money manager proposals for investors new to our firm. A good portion of these new investors coming to us have the biggest portion of their investment portfolios in cash and are looking to get better than money market and short- term Treasury returns. I believe this is a good insight as we see money move from the 3+ trillion sitting in cash on the sidelines.
One additional benefit of dividend-paying stocks: The Jobs and Growth Tax Relief Reconciliation Act of 2003 dramatically cut the federal tax rate on stock dividends, from a maximum of 38.6% to 15%. That rate was scheuled to expire on December 31, 2008. But the Tax Increase Prevention and Reconciliation Act of 2005 extended the lower tax rate through 2010, and further cut the tax rate on qualified dividends to 0% for individuals in the 10% and 15% income tax brackets. As sunset provisions take effect in 2011, taxation of dividends could return to pre-2001 levels, however.
Remember, though, that stocks of any kind, including dividend-paying stocks, have risks. The whole point of holding cash and bonds as well as stocks is to diversify your portoflio, and therefore help temper its overall risk—so we’re not encouraging you to move all of your assets to dividend-paying stocks. How much you do move, if any, will depend on your individual financial circumstances that we will help uncover with you.
That said, even Bill Gross, the bond guru who oversees $1 trillion in fixed-income investments at Pimco, has been urging investors to move out of cash and bonds and into stocks with high dividends. “[S]hort-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets…will involve just that—risk,” he wrote in his July 2009 market commentary. “Investors should stress secure income offered by bonds and stable dividend-paying equities.”
We believe that money manager selection for each of our clients needs to be customized to their personal goals. Some clients are focused on secure fixed income while others are looking for higher returns with what I believe are the best managers to help them do that. But the majority of our clients are somewhere in the middle. They like to be in stocks that cover the spectrum of asset classes, some aggressive and some dividend payers. WrapManager’s core belief is the “Power of Diversity.”
We are currently recommending Federated Investors, Inc., a money manager we believe is one of the best for our clients looking to take advantage of a dividend paying strategy. Federated’s main objective is to produce high current income by focusing on companies that have a history of growth in their dividend income. The portfolio as of 1/1/2010 had a dividend yield over 5%. That is more than 2 times the current dividend yield of the S&P 500. Federated Investors states that “the outlook for our dividend income style has never been better…to purchase high-quality stocks, offering historically high dividends yields and reliable dividend growth opportunities.” This manager also has past returns that show they have lower beta, appx .61, which has translated into much less volatility than the S&P 500. Learn more about this investment opportunity, and how this experienced money manager—managing money since 1970 and with current assets over $1.5 billion—could become an important part of your portfolio.
Discover more about Federated Investors, Inc. Strategic Income
1The S&P 500 Index is widely considered representative of the US equity market. Index returns assume reinvestment of all distributions and do not reflect any fees or expenses. It is not possible to invest directly in an index.
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