Independent Investor: Are Dividend Stocks a Good Investment?

Dividend stocks have outperformed nondividend paying stocks since 1972. However, the companies that had provided the best track records in paying and increasing their dividends have either been acquired, stopped raising dividends or in some cases even eliminated them. Given that a large number of baby boomers are set to retire in the next few years with definite income needs, I believe that the demand and supply of dividend paying stocks will only increase.

But the last few years of turmoil have shaken the confidence of many dividend believers. In the S&P 500 Index about 370 stocks pay dividends at any given time. In 2009, those dividends declined by 20 percent. That's on top of a 35 percent sell-off in stock prices in 2008. For those dividend investors living on the income generated from their portfolios, this double whammy was devastating.

A great many investors finally threw in the towel, sold out and moved to the sidelines in the beginning of 2009. In hindsight, that was the wrong move. Even today a lot of those investors have not re-entered the market.

Although dividends gained back 5 percent last year, they are still 17 percent below the level companies paid in 2008. Some pundits believe that it will take until 2013 before dividends are back to the 2008 level. That may be true for some companies but not all companies are the same

For example, the 70 companies with the highest annual dividend growth rate over the past three years have outperformed 58 percent of all stocks in the S&P. They are predominantly mature businesses that have strong cash flows, stable profit outlooks and lower operational risk, on average, than other companies. In my opinion, if an investor does his due diligence on a targeted list of companies, he or she can be rewarded with both additional yield as well as some price protection. But the devil is always in the details.

Recently a reader asked if dividend payers perform well in an inflationary economy; evidence indicates they do.

In the period 1974-1980, when the inflation rate was 9.3 percent, the return on the S&P index averaged 9.9 percent a year. The dividend component of this return (4.9 percent) accounted for nearly half of the overall return. Obviously, if things go the other way (a deflationary environment), dividend payers shine because they are, by definition, defensive and provide a stream of income.

I believe we are in an economic recovery. Economic and earnings cycles typically encourage and support accelerating dividend growth and this recovery should be no different. In addition, many companies hold a record amount of their net worth in cash due to the peculiar nature of this last recession. I believe managements will use that cash to increase dividends and/or buyback stock.

This is where your due diligence comes in. If you did your homework, you would discover that just 10 stocks account for 32 percent of the cash (ex financial companies) in the S&P 500. Those 10 stocks receive an average of 56 percent of their sales from outside the U.S.

If you further believe that the dollar will continue to decline and that some overseas markets will grow at a faster clip than the U.S., then it makes sense to look at those 10 in relation to how much dividends they generate.

That is not the only criteria an investor should use in selecting dividend stocks. Free cash flow coupled with strong earnings growth, low debt to equity, a track record of increasing dividends over at least 5, if not 10 years, are just some of the variables investors should use to fashion a high-quality dividend portfolio.

Unfortunately, many investors simply look for the highest-yielding securities they can find. That only works in a bull market. At the first sign of problems, those yields evaporate along with the price of the stock. That brings up the final issue. How to invest in dividend stocks in today's markets?

Readers are aware that I am not an advocate of the buy-and-hold investment philosophy. I believe firmly that we are in a long-term bear market that could last for another 5 or 6 years. Right now we happen to be enjoying a rally that could continue for another 6 months to a year, but at some point it will end. Therefore the investor must mange risk and no longer depend on just the dividend to cushion declines in his portfolio. You might, for example, establish a rule that a company that cuts its dividend is an automatic sell or begin to liquidate stocks once the S&P 500 index breaks its 200 day moving average. The point is that you must manage your portfolio actively, which requires a lot of work.

Another highly recommended alternative is to hedge your portfolio with covered options. The cost of that protection will reduce your overall returns but you will sleep better at night knowing that if we revisit the declines of 2008-2009 your portfolio will at least be protected from price declines. Bottom line: dividend stocks do have a place in your portfolio, if you are willing to work for it.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.