The Case For Cyclicals In A Dividend Growth Portfolio

| About: Materials Select (XLB)

Readers of my previous articles know that I am a strong advocate of dividend growth investing. Dividend growth investors often focus on consumer staple names like Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), and Clorox (NYSE:CLX). These are great stocks to pick up whenever they go on sale, because they have an inbuilt advantage: demand for their products is relatively inelastic. In good times or bad, people will still be stocking their bathrooms with shampoo and toilet paper, cleaning their houses with bleach, and drinking soda and eating Doritos.

But this is somewhat of a two-edged sword: the fact that demand is relatively inelastic for consumer staples means that when economic growth is strong, such stocks will get left behind. After all, regardless of the size of my year-end bonus, I'm not going to be buying any extra toothpaste. Thus, while consumer staples typically outperform in down economies, they don't have as much potential in up economies.

This point is illustrated by the performance of the highly cyclical Materials Select SPDR ETF (NYSEARCA:XLB) versus the defensive Utilities SPDR (NYSEARCA:XLU) and Consumer Staples SPDR (NYSEARCA:XLP). While the materials sector has severely underperformed as of late, due to fears about macro factors, a look at the charts shows that over the longer term, materials have still outperformed.

Click to enlarge (Source: Google Finance)

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It's easy to get tunnel vision when thinking about dividend stocks. Most of the dividend growth investing articles I see are predominantly focused on consumer staples names like Coke and J&J. However, these aren't the only dividend stocks around - 80% of S&P 500 (NYSEARCA:SPY) companies pay dividends. In fact, the Materials SPDR paid 2.1% in dividends in 2011, counting yield at each reinvestment price. (Namely, 100 shares of XLB at the start of 2011 increased to 102.1 shares of XLB at the start of 2012, ignoring quarterly compounding.)

In comparison, the Consumer Staples SPDR paid out 2.86% using the same methodology. Individual names can pay even higher dividends: for example, DuPont (NYSE:DD) pays a 3.46% dividend that stacks up well against the 3.51% dividend of JNJ, the 2.51% dividend of KO, and the 3.45% dividend of PG. While DuPont doesn't increase the dividend every year, there are other materials stocks that do: Air Products & Chemicals (NYSE:APD), which currently yields 3.15%, has consistently increased dividends and was named to the Dividend Channel's "SAFE 25" list of top dividend stocks.

In conclusion, for investors with a 10-20 year time frame, holding dividend-paying cyclicals is a good way to increase total return. While the dividends may be smaller than in other sectors, the larger capital gains can easily make up the difference. With cyclicals like the materials sector having sold off in light of macro fears, now might be a good time to pick up some cyclicals for your portfolio.

Disclosure: I am long CLX, JNJ, KO, PEP, PG.

Additional disclosure: I also have a position in the Fidelity Select Materials Portfolio (MUTF:FSDPX).