Dividend Stocks, Bonds And The Real Enemy

by: Tim McAleenan Jr.

David Nicklaus, one of the financial columnists who writes for the St. Louis Post-Dispatch, recently wrote an article chiding some investors for conflating savings accounts, CDs, and bonds with the highest quality dividend-paying stocks. In his argument, Nicklaus does make a point of distinction I agree with. Savings accounts are guaranteed by the federal government, and companies can lose value, stop paying a dividend, or go bankrupt. When you put $10,000 into your account at Commerce Bank (NASDAQ:CBSH), there's no wipeout risk as long as the U.S. government remains solvent and the current laws on FDIC insurance remain in place. When you buy shares of Chevron (NYSE:CVX), the price of oil could fall off a cliff, potentially forcing the company to stop paying its dividend. So I understand the point that Nicklaus is making. He has this to say in his article:

Rock-bottom rates on bonds and savings accounts have many investors reaching for income wherever they can find it. Increasingly, their reach extends to the stock market, which tantalizes them with dividend yields such as AT&T's (NYSE:T) 5.6 percent or Johnson & Johnson's (NYSE:JNJ) 3.5 percent. But, like a handyman who stands on the top rung of a ladder despite the red 'unsafe' warning, the yield-hungry investor is taking a risk that's far out of proportion to the extra income he or she might expect. After all, no matter how stable a name like Procter & Gamble (NYSE:PG) may sound, you can't compare its 3.1 percent dividend yield to the 1.05 percent interest on a five-year Treasury bond. Owning a stock means your entire investment is at risk: Kodak and General Motors (NYSE:GM) were reliable dividend payers not long before they descended into bankruptcy. The dividend is not guaranteed, either. In March 2009, after General Electric's (NYSE:GE) stock price had plunged 72 percent in a year, the bluest of blue chips added insult to investors' injury by slashing its dividend 60 percent…

If you own stocks, directly or through mutual funds, you probably earn some dividends, and that's OK. The dividend payers only get dangerous if you start to see them as a substitute for your bank CDs or Treasury bonds. 'They are still stocks, and there's stock market volatility and risk associated with them,' emphasizes Don Kukla, chairman of Moneta Group in Clayton.

When Nicklaus makes his argument against dividend stocks in comparison to bonds, I think he becomes so eager to make his point (you can tell by the tone of his comments in lines like "you probably earn some dividends, and that's OK," that no one is going to accuse him of being a 'dividend zealot' any time soon) that it comes at the expense of giving the dividend crowd a fair shake. When I define investing risk, one component of that is the fear of losing purchasing power to inflation. What do you think happens if you buy that 1.05% yielding five-year Treasury bond? You are guaranteeing that you will lose purchasing power for as long as you hold the 1.05% bond and the inflation rate in this country remains over 1.05%. If inflation runs at 3% annually, you are losing about 2% every year that you continue to hold onto the bond. That's what scares me as an investor - the potential that the money I hold today will not be able to purchase as much tomorrow as it can today.

And when Nicklaus points out the risk of General Motors and Eastman Kodak going bankrupt, as well as General Electric's dividend decline, I think he is making somewhat of a strawman argument. Sure, if you only own a couple dividend-paying stocks, the risk of loss if you happen to hold one of these companies can be enormous. But what if you hold a diversified portfolio of the "Greatest Hits" in the dividend stock universe? Let's say that you own the following 30 stocks: Exxon (NYSE:XOM), Chevron , Conoco Phillips (NYSE:COP), Clorox (NYSE:CLX), Colgate-Palmolive (NYSE:CL), McDonalds (NYSE:MCD), Pepsi (NYSE:PEP), Coke (NYSE:KO), Johnson & Johnson , Kimberly Clark (NYSE:KMB), Aqua America (NYSE:WTR), Procter & Gamble , Wal-Mart (NYSE:WMT), Walgreen (WAG), Abbott Labs (NYSE:ABT), Altria (NYSE:MO), Philip Morris International (NYSE:PM), Nestle (OTCPK:NSRGY), Emerson Electric (NYSE:EMR), 3M (NYSE:MMM), Brown Forman (NYSE:BF.A), Church & Dwight (NYSE:CHD), Intel (NASDAQ:INTC), IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT), Becton Dickinson (NYSE:BDX), Realty Income (NYSE:O), Unilever (NYSE:UL), HJ Heinz (HNZ), and Campbell Soup (NYSE:CPB). That's going to be a hard battleship to sink.

If I owned these 30 stocks, I would feel very confident that my total dividend income would rise by a greater amount each year than the rate of inflation - even if the occasional General Electric during the financial crisis hampers the portfolio. But when I buy a 1.05% yielding bond, I am virtually guaranteeing that I will be losing purchasing power in exchange for not having to deal with the volatility of price fluctuations. But when I buy shares of the 30 companies listed above for the purpose of income generation, I am effectively saying, "I am willing to deal with sharp price declines-sometimes in the neighborhood of 50% during recessions - because the fluctuations in my portfolio's net worth are justified by my likely successful pursuit of a growing dividend stream that beats inflation."

The hard part of trying to analyze the Nicklaus article is that it's not entirely clear what purpose the investor debating between 1.05% yields and dividend stocks is working toward. Is this money needed in one month? One year? One decade? What are the personal circumstances for the investor? For instance, most of us should probably have an emergency fund that is very stable without us trying to earn a return on it. But still, we're making a declaration of sorts when we set aside $7,000 in a rainy day emergency fund. We're effectively saying: "The stability of having money when we need it is worth the 2% loss of annual purchasing power because I don't want to deal with the potential of a medical emergency, car breakdown, or job loss without having some easily accessible money in my life. I want a margin of safety." That makes complete sense, and that's certainly a tradeoff I'm willing to make.

But beyond emergency fund money, what's the next step? What are our goals? I can tell you mine: Once I have an emergency fund established, my objective as an investor is the pursuit of increased purchasing power via organic dividend generation. I have no interest in trying to temper my portfolio's market value volatility by guaranteeing that I will lose purchasing power with 1.05% bonds. I can deal with the portfolio volatility of the 30 stocks that I mentioned above because I believe that the annual dividend increases will raise my annual passive income generation by an amount greater than inflation, and the fluctuating market values are just background noise. Inflation - namely, the loss of our purchasing power - is the omnipresent bogeyman that we as investors must always combat, and I wish that Nicklaus would have compared a comprehensive dividend portfolio with those 1.05% yielding bonds. Maybe the dividend investors who refuse to lock-in losses of purchasing power wouldn't look so stupid.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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