Thursday, March 30, 2006

Great Article About Dividends At Morningstar.com

Yesterday I was persuing the Yahoo Finance website when I saw a great article about dividends and why they have come back into favor and will become increasingly important in the future.

I highly recommend reading the following article, entitled "Ride the Retiree Wave with Dividends":

It's no secret what's about to crash onto the shores of the American economy. Rather than working for money, the massive baby boom generation expects to have its hard-earned money work for it.

At the same time, another megatrend is rolling through corporate America. Despite all-time record profits, big business isn't investing in new factories, stores, and workers the way it usually does--and the cash is piling up.

If this sounds like a dream scenario for dividend investors, well, it just might be real. We're certainly focusing on these trends in Morningstar DividendInvestor, which I edit. (Click here for more information, including a risk-free trial subscription.) But we can't just buy any dividend-paying stock and expect the newly retired to run it up; a lot of traditional income sectors like real estate investment trusts and utilities are already expensive. If we're going to ride the wave from here, we need an unconventional strategy:

1) Buy dividend potential, not just current yield
2) Look for unconventional sources of income

. . .

2 comments:

Miserly Bastard said...

The author of this article posits an increase in dividend yield in the future.

One problem with this hypothesis is that dividend yield can rise in one of two ways.

Either management can increase the dividend, and the stock price can remain the same. This is great if it happens.

The other way for dividend yield to rise is for the stock price to fall and for the dividend to remain the same. This is bad, bigtime.

Thus, one of the problems with buying stocks for their dividends is that you face a fair amount of exogenous risk to the principal. Equity markets can fall, analysts can downgrade, companies can miss earnings, competitors can weaken an entire sector, etc.

By contrast, the dividend yield on investment grade bonds tends to be driven by interest rates only. There is much less credit-specific risk. And where there is such risk (such as call risk), this can be diversified away by buying a bond portfolio instead of an individual bond.

Overall, if you're looking to buy a dividend only, I think it makes much more sense to buy bonds. To purchase equity, you need to expect that the equity risk premium will compensate you through appreciation in the underlying instrument.

Jim said...

What you say is theoretically true. However, investing in a broad index to capture dividend payments minimizes the single company-specific risk.

According to Table 1 of this article, http://www.cicbv.ca/miscellaneous/documents/dividendsandstock.pdf , the average annual increase in dividends by the S&P 500 index companies was 5.74% annually between 1946 and 2003.

As illustrated in my previous post, http://financeandinvestments.blogspot.com/2006/02/sp-500-dividends.html , S&P 500 dividends did actually increase in 2000 and 2001. However, since 2002 they have been steadily rising and are at an all-time high.

I agree with you to the extent that someone who wants investment income but might need to pull their money out of the income-producing investment in the near future should invest in bonds instead of dividend-paying stocks. However, over long periods of time (10+ years), people who invest in dividend-paying stocks will come out far ahead of people who invest in bonds.

The only way bond-holders will come out ahead in the long run is if this country experiencing a deflationary spiral or depression.

Even though it may expire in 2008, the current lower tax rate for dividends also increases the attraction of dividend-paying stocks.