The Case For Dividend Growth Stocks

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 |  Includes: AMJ, EFA, GLD, MSFT, PID
by: Charles Lewis Sizemore, CFA

As the wise King Solomon noted 3,000 years ago, “to everything there is a season.” Solomon had no knowledge of the stock market, of course, but his words can certainly be applied.

There is a time to be invested in growth stocks—such as the 1990s—and a time to be invested in value—such as the mid-2000s. And as recent experience has shown, there is a time to be out of the market altogether.

So what “season” might we be in today? If the last two months of volatility are any indication, a rough one.

For the past year, I’ve been advocating a high-dividend strategy, though this was more by process of elimination than anything else. Consider:

  1. Bonds, by and large, do not yield enough to warrant serious consideration. Why risk capital loss for a puny 2.0% yield? You’d be better off keeping your funds liquid, in cash. But…
  2. Cash pays virtually zero. Even if inflation remains benign—and the history of credit bubbles and busts suggest it will—you’re likely going to see a negative real return on your cash for the rest of this decade.
  3. Stocks, though cheap, can get a lot cheaper. While I am not a bear by any stretch, investors should have reasonable assumptions about market returns. Stocks may go much higher from current levels, but given the ongoing fallout from the U.S. mortgage crisis and the never-ending sovereign debt drama coming out of Europe, it promises to be a rough ride.
  4. Gold (NYSEARCA:GLD) is exhibiting all of the signs of a bubble, and that bubble may already be in the process of deflating (see “Is it Time to Call the Top?”). But even if gold enjoys another leg up, do you want to bet your financial future on an asset whose value is determined purely by the whims of speculators? Remember, gold has no intrinsic value. It has no earnings, and it pays no income. It’s worth only what the market says it’s worth today, and the market can be a rather fickle mistress.
  5. Oil and gas Master Limited Partnerships (NYSE: AMJ) and subsectors of the REIT universe that are less economically sensitive—such as apartments , self-storage, or senior living facilities—are priced reasonably and generally pay out a healthy amount of cash distributions. But you can’t put your entire net worth into pipelines and REITs. Both are highly sensitive to interest rate movements and to changes in the tax code. As investors in the Canadian royalty trust sector learned a few years ago, changes in the tax code can absolutely wreck a portfolio. Most financial planners would not advocate putting more than 10-15% in each, and I am inclined to agree.

So, for lack of anywhere else to go, I come back to high-dividend equities. The case here is pretty straightforward. Stocks that pay a dividend guarantee you at least a modest realized return, even if the share price goes nowhere. And most importantly, healthy companies raise their dividends over time, and not always by a trivial amount. Microsoft (Nasdaq: MSFT) , for example, raised its dividend by a full 25% this quarter.

The other case for dividends is more philosophical. When a company raises its dividend, it sends a very important message that management is confident about the company’s future and that it takes its obligation to reward shareholders seriously. And if a company is able to raise its dividend during crisis years like 2008—when plenty of companies had to slash their dividends to preserve cash—you know they can survive Armageddon.

With that said, let’s take a look at how the PowerShares International Dividend Achiever ETF (NYSE: PID) held up during the recent spate of volatility emanating from Europe. This ETF is composed of non-U.S. (mostly European) companies that have raised their dividend for a minimum of five consecutive years—years that include the annus horribilis of 2008. For comparative purposes, I graphed Dividend Achiever ETF against the larger iShares MSCI EAFE ETF (NYSE: EFA), which is also primarily composed of European stocks.

Figure 1: PID vs. EFA, click to enlarge

Not shockingly, the Dividend Achiever ETF took less of a beating over the past three months. It did, however, still manage to lose 10%.

What are we as investors to take away from this?

To start, during a short-term panic or a liquidity crisis, all stocks fall. So, if you need access to your funds in the near future the same rules as always apply: don’t put funds into the market that you need in the immediate future for basic necessities. And if you believe that stocks in general are wildly overpriced or at particular risk of a major correction (or if there are simply better investment options out there), then by all means, stay out.

But if you believe, as I do, that the market will move mostly sideways over the next several years (with random and hard-to-predict mini-booms and mini-busts scattered throughout), then a dividend growth strategy is the way to go. Investors in or near retirement can use the dividends to meet current living expenses. And investors investing for long-term growth can reinvest the dividend and put the magic of compounding to work.

In an environment in which returns can be hard to come by, take the dividend check in the mail.

Disclosure: I am long PID, MSFT, AMJ.