No Options Today Create Future Risk For Total Return Ideas

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 |  Includes: DGRO, DGRW, NOBL, PFM, RDVY, SDY, VIG
by: Patrick J. O'Hare

Summary

Dividend-paying stocks are a great source of income, but they are not risk free.

When interest rates rise, so too will the competition for dividend payers.

The Dividend Aristocrats face price risk just like other companies that don't pay a dividend.

I penned a column for The Big Picture a few weeks ago entitled Outsized Gains Driven by Fun-duh-mental Strength. My conclusion, which followed form with the recent update to our Market View, was that it is advisable to proceed with caution in the near term since the risk-reward dynamic isn't that appealing. The point I made in that piece was that the stock market was being moved increasingly by speculative behavior than it was by fundamentals.

Soon after posting the column, I received an email from a reader who wanted to share his take on the market action the last couple of years. He wrote the following:

"Baby boomers are seeking some kind of decent return and income. Both those retired and those near to retirement. 5% to 7% range. Only stocks and dividends on stocks are returning close to those numbers. There is no other option for them. So... although it may be obvious... that doesn't make it wrong."

I always enjoy hearing from Briefing.com readers whether they agree with my viewpoint or not. Differences of opinion are what make a market. Differences of opinion also help analysts like myself think with an open mind.

What the reader said made a lot of sense. Savings rates are pathetic. CD rates are only a little less pathetic. And Treasury rates don't offer much, if anything, in the way of real returns. It is little wonder in the current environment that retirees and those near to retirement would be looking to the stock market for income generation. The Federal Reserve's monetary policy has all but commanded them to do just that.

What I wrote back to the reader was the following:

"I agree with your observation. Demographics are playing an important role and even more than they might be otherwise because the Fed is forcing the hand into higher-yielding instruments. The concern I have is that there is a lot of leverage (literally and figuratively) tied up in the idea that there is no other option. That seems true today in an obvious sense, but I can't help but think that it was also obvious at one point that home prices in the US, broadly speaking, don't go down. That understanding ended up coming back to bite a lot of people (including yours truly). It isn't wrong for baby boomers to seek better sources of return and income through the stock market. It can obviously be a great source for that. I'm just aiming to keep readers mindful that it's not a risk-free undertaking even though there doesn't appear to be any other option today."

Finding Favor In Dividends

Regular readers know that I often sing the virtues of owning dividend-paying stocks. In doing so, I typically point readers in the direction of the S&P 500 Dividend Aristocrats. Those are companies in the S&P 500 that have raised their dividend every year for at least 25 consecutive years. These companies, therefore, don't just pay dividends, they also provide reliable dividend growth which is an important element for income-oriented investors.

History has shown that dividend-paying stocks do wonders for enhancing investment returns over the long-term. The chart below comparing the S&P 500 Price Index to the S&P 500 Total Return Index says it all in that respect.

In the aftermath of the financial crisis, and the subsequent repression of interest rates, more and more investors appear to have gained an appreciation for dividend payers. That point tends to get lost amid all of the attention paid to the huge price gains made by the S&P 500 since the March 2009 bottom.

The fact of the matter is that the price gains made by the S&P 500 trail the price gains made by the S&P 500 Dividend Aristocrats over the same period.

Strikingly, the performance gap has widened noticeably over the last two years when, incidentally, the leading edge of the baby boomer generation hit retirement age and the yield on the 10-yr note hit an all-time low.

Different Times for Dividend Aristocrats

There was a period in the late-1990s when dividend-paying stocks were outcasts in the stock market. The general interest in buying them took a distant backseat to the general interest in buying any stock with a dot-com suffix or any stock that was tethered to the promise of the Internet. That all changed, however, when dot-com turned into dot-bomb beginning in March 2000.

The table below makes it plain to see that investors quickly found dividend-paying religion when the tech bubble/growth stock bubble burst. Suddenly, many of the stodgy blue chips were back in fashion as investors turned back to fundamentals and away from the fun-duh-mentals of the dot-com mania.

The table below also shows, however, that most of the Dividend Aristocrats didn't escape unfazed from the carnage of the financial crisis. Many still fared better overall than the S&P 500, yet the capital losses were still material in most instances.

Company

Symbol

Sector

3/24/00 -10/19/02

10/9/07 - 3/9/09

Dividend Yield

3M

MMM

Industrials

31.3%

-54.0%

2.40%

Abbott Labs

ABT

Health Care

25.3%

-11.6%

2.10%

Aflac

AFL

Financials

28.5%

-79.6%

2.40%

Air Products & Chemicals

APD

Materials

48.1%

-52.2%

2.40%

Archer Daniels Midland

ADM

Consumer Staples

35.6%

-21.1%

2.10%

AT&T

T

Telecom Services

-49.0%

-44.9%

5.20%

Automatic Data Processing

ADP

Technology

-32.1%

-28.8%

2.40%

C.R. Bard

BCR

Health Care

31.8%

-18.1%

0.60%

Becton Dickinson

BDX

Health Care

5.5%

-23.6%

1.80%

Bemis `

BMS

Materials

44.1%

-37.9%

2.60%

Brown-Forman 'B'

BF.B

Consumer Staples

42.1%

-29.4%

1.60%

Cardinal Health

CAH

Health Care

87.4%

-54.1%

2.00%

Chevron

CVX

Energy

-13.6%

-34.3%

3.20%

Chubb Corp.

CB

Financials

-7.5%

-34.9%

2.10%

Cincinnati Financial

CINF

Financials

1.5%

-56.9%

3.60%

Cintas Corp.

CTAS

Industrials

8.6%

-49.3%

1.20%

Clorox

CLX

Consumer Staples

28.6%

-22.9%

3.20%

Coca-Cola

KO

Consumer Staples

13.9%

-30.07

2.90%

Colgate-Palmolive

CL

Consumer Staples

3.5%

-21.9%

2.10%

Consolidated Edison

ED

Utilities

61.5%

-25.6%

4.40%

Dover Corp.

DOV

Industrials

-46.3%

-55.3%

1.70%

Ecolab

ECL

Materials

27.9%

-35.1%

1.00%

Emerson Electric

EMR

Industrials

-4.3%

-52.6%

2.50%

Exxon Mobil

XOM

Energy

-10.2%

-28.3%

2.70%

Family Dollar

FDO

Consumer Discretionary

30.0%

15.4%

1.80%

Franklin Resources

BEN

Financials

-15.6%

-70.9%

0.80%

Genuine Parts

GPC

Consumer Discretionary

40.9%

-46.6%

2.60%

W.W. Grainger

GWW

Industrials

-25.0%

-33.4%

1.70%

HCP, Inc.

HCP

Financials

97.6%

-48.3%

5.30%

Hormel Foods

HRL

Consumer Staples

58.8%

-15.0%

1.60%

Illinois Tool Works

ITW

Industrials

-2.8%

-54.5%

1.90%

Johnson & Johnson

JNJ

Health Care

60.9%

-26.6%

2.70%

Kimberly-Clark

KMB

Consumer Staples

4.9%

-34.3%

3.00%

Leggett & Platt

LEG

Consumer Discretionary

3.3%

-44.2%

3.50%

Lowe's

LOW

Consumer Discretionary

40.3%

-51.7%

2.00%

McCormick & Co.

MKC

Consumer Staples

71.6%

-14.2%

2.00%

McDonald's Corp.

MCD

Consumer Discretionary

-51.7%

-2.9%

3.20%

McGraw-Hill

MHFI

Consumer Discretionary

22.3%

-66.4%

1.50%

Medtronic

MDT

Health Care

-19.7%

-56.2%

1.90%

Nucor

NUE

Materials

-19.8%

-43.9%

2.90%

Pentair

PNR

Industrials

-5.2%

-46.9%

1.30%

PepsiCo

PEP

Consumer Staples

30.4%

-34.9%

2.90%

PPG Industries

PPG

Materials

-11.2%

-60.0%

1.30%

Procter & Gamble

PG

Consumer Staples

65.8%

-35.6%

3.20%

Sherwin-Williams

SHW

Materials

4.7%

-31.3%

1.10%

Sigma-Aldrich

SIAL

Materials

91.7%

-35.9%

0.90%

Stanley Black & Decker

SWK

Consumer Discretionary

28.8%

-58.4%

2.20%

Sysco

SYY

Consumer Staples

73.7%

-41.4%

3.10%

T. Rowe Price

TROW

Financials

-42.0%

-62.9%

2.10%

Target

TGT

Consumer Discretionary

-21.7%

-60.6%

3.60%

VF Corp.

VFC

Consumer Discretionary

37.8%

-39.0%

1.70%

Walgreen

WAG

Consumer Staples

17.3%

-44.0%

1.70%

Wal-Mart

WMT

Consumer Staples

-7.4%

7.4%

2.50%

Click to enlarge

Source: Yahoo! Finance (returns adjusted for splits and dividends)

What It All Means

If interest rates continue to remain low, there should continue to be steady demand for dividend-paying stocks and especially the cream of the dividend-growth crop like the Dividend Aristocrats.

That understanding today continues to lead income-oriented investors into the names. What cannot be forgotten today, however, is that these stocks are at risk of a price correction just as any stock of a company that doesn't pay a dividend is.

If the income generated by the dividend payment is all that matters to an investor, then one can worry a whole lot less about any future price corrections. However, if one may need access to the capital that is tied up in the investment in dividend-paying stocks, it will behoove one to consider their risk exposure there today and perhaps consider taking some money off the table following a big run by many of the names that has been aided by the Fed's ultra-accommodative policy.

Eventually, the Fed will be raising rates. The market thinks that will likely happen in the latter half of 2015. As the Fed raises rates, market rates will increase and will provide more competition for the dividend payers. At the same time, those higher rates may actually upset the stock market and lead to a broader price correction that pulls down the dividend payers.

There may not be another option today for total return opportunities, but when other options do avail themselves in the future, it is apt to become clear that today's only option is not risk free.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.