Finding Favor in Corporate Dividends

Brett Hammond, Senior Economist

Brett HammondThe S&P 500 finished 2011 almost exactly where it began – falling just four one-hundredths of a point. This flat-line performance, however, has masked a wide diversity in the performance of different categories of stocks. For example, companies paying high dividends strongly outperformed those paying low dividends. For investors, we believe that companies paying dividends may be an attractive investment option over the long term, particularly in periods of depressed economic growth.

Strong performance
There are three primary reasons why dividend-paying stocks are attractive. First, they have performed well. According to research firm Birinyi Associates, the stock prices of the highest-yielding 100 companies in the S&P 500 were up an average of 3.7% through mid-December. The 100 lowest-yielding stocks had declined an average of 10%.

Second, we believe dividend-paying companies will deliver favorable risk-adjusted returns over the long term. The aging of the U.S. population, and the altered consumption patterns that will ensue, may limit economic growth over the long term. In such an environment, dividend-paying stocks may become attractive investments. During periods of low growth, companies generating increasing cash flows will be attractive. In such an environment, some companies will conclude that shareholder distributions are the most efficient approach to managing that cash (other alternatives include investing it, sitting on it or buying back company stock). For older investors who have moved into a lower tax bracket, dividends can be attractive because the income will be taxed at a lower rate. These investors may also be drawn to the prospect of their investments delivering more immediate income gains.

Third, as we have seen it, the stock prices of dividend-paying companies are typically less volatile than those of growth companies. This might appeal to investors with a lower tolerance for risk.

Of course, dividend-paying stocks have traditionally had different return patterns than growth stocks. With growth stocks, investors are essentially “banking on the future,” since these companies are typically relying on the potential for outsized future revenue growth rather than current cash flows.

Cautiously optimistic
We are optimistic about dividend-paying companies, albeit with some conditions. The strong performance of these companies recently raises the risk that their stock prices could be inflated – in other words, tomorrow’s expected gains may already be reflected in today’s prices. Moreover, with the U.S. economy expected to perform slightly better in 2012 than in 2011, the performance of growth stocks should improve.

Sectors to follow
Investors seeking out dividend-paying companies should look to sectors where there is typically steady demand and predictable cash flow. Examples include utilities and household goods, since consumers are less likely to put off making purchases in these sectors. By contrast, in sectors that are defined by more discretionary buying patterns, such as information technology or automotive, cash flow is often more volatile and dividend payments are less likely.