Thursday, February 12, 2009

The Dividend Edge

During the 1982-2000 secular bull market, investors were looking for quick capital gains in hot growth sectors. Dividend stocks were viewed as something that is appealing to older investors. As stock prices rose to the stratosphere dividend yields on the S&P 500 fell to as low as 1%, which left long-term investors with a smaller cushion against market declines.
With the 2003 lowering of taxation on dividends, income-producing companies have been in vogue with investors. There are many reasons why dividend stocks are superior to non-dividend stocks.
One reason is that most stocks rise and fall on average at the same pace as the market. Stocks that pay dividends however, offer an extra incentive to hold on to them during tough times.
Another reason to hold on is that most dividend stocks represent mature companies with stable business models that generate much more in earnings than what could be re-invested back into in the business. Slower growth companies will generally experience much lower drops in share prices in comparison to hot growth sectors.
Furthermore the quarterly dividend payment will provide investors with a relatively safe cushion against bear market declines, as most companies keep sending their dividend checks monthly or quarterly to shareholders. During market declines it is very tough to generate any capital gains. The dividend is the only item that increases investors total returns during severe corrections.
Most corporations that pay a portion of their profits to investors prove that earnings are real, and not a result of the manipulation of GAAP rules. More important is the fact that once management has set a dividend policy of a stable or a rising dividend payment, only an unforeseen event or a major fiasco in the company’s business model will derail that commitment. Unlike share buybacks, which could be canceled quietly, a dividend cut or suspension will most likely anger stockholders. When a company commits to paying a dividend, management is much more careful with approving projects that might not yield a sufficient return on investment.
Most investors have heard the headlines in 2008, which included major dividend cuts from companies such as Bank of America, Citigroup and a plethora of other financial stocks. The majority of dividend cuts however, have been concentrated in the financial sector. Even during recessions, most corporations keep their dividends either unchanged or slightly higher. The current recession is no exception so far.
Even during bear markets, dividends have a much lower volatility in comparison to stock prices.
According to Ned Davis Research, dividend paying stocks have also outperformed non dividend paying stocks over the past 35 years.
Even in 2008, despite the financial crisis, dividend payers in the S&P 500 still managed to outperform non-dividend payers, according to Standard & Poors.The same was true for 2007 as well as for 2006.

Investors can gain an even more profitable edge by focusing on dividend growth investing. There are several recession resistant dividend stocks, which should be the cornerstone of any dividend growth portfolio, provided that they are accumulated at bargain prices.

PepsiCo (PEP) – This consumer staple has been increasing its dividends for 36 consecutive years. Over the past decade PEP has managed to almost triple its EPS and deliver a total dividend growth of 227%. The maker of Pepsi Cola and Frito-Lay chips is currently yielding 3.40%. Investors who were lucky enough to purchase this dividend aristocrat 20 years ago at $6.50 are currently generating a 26% yield on the cost of their original purchase. I expect PEP to keep delivering by increasing its dividend in May, as it has been doing for the past several years. Check out my analysis of Pepsi.

Johnson & Johnson (JNJ) is another consumer staple whose product sales are less likely to suffer during recessionary times. This dividend aristocrat has been rewarding shareholders for 46 years with increasing dividends. Over the past decade EPS have grown from $1.47 to $4.57, while dividends have risen by 229%. Investors who purchased JNJ stock 20 years ago are now earning a respectable yield on cost of 34%. Johnson & Johnson currently yields 3.20%. Check out my analysis of Johnson & Johnson.

Procter & Gamble (PG) focuses on brand products in over 180 countries worldwide, by focusing on three major business segments – Beauty and Health, household Care and Gillette. P&G is another consumer staple whose products consumers can’t live without and which they use even during tough times. PG has had a slower dividend growth of 180% over the past decade, while its EPS increased from $1.30 to $3.64 over the same period. PG currently spots a modest dividend yield of 3.10%. Investors who ignore it and focus on the current highest yielding stocks should be reminded that a long-term investment in PG 20 years ago would be yielding almost 30% on cost. Check out my analysis of Procter & Gamble.

Mcdonald’s (MCD), which is the largest fast food restaurant operator in the world, has been somewhat immune from the financial crisis, as it keeps posting solid increases in its same store sales. I especially like the fact that the company always seems to unveil new innovative items on its menu, which consumers can’t get enough of. As a result its earnings per share have almost tripled over the past decade from $1.39 to $3.76, while dividends increased almost 10 times. Long-term shareholders of MCD who purchased stock 20 years ago have seen their yield on cost rise to 34% over the course of their investment. The dividend payout for the golden arches also looks conservative, which increases the chances that the company will continue its uninterrupted streak of 32 consecutive annual dividend increases. Check out my analysis of McDonald's.

Kimberly Clark (KMB) is a slower growing dividend aristocrat, which has nevertheless raised its dividends for 36 years in a row. The slower growth helps explain its high current yield at 4.70%. While revenues and earnings per share have increased over the past decade, the overall net income that KMB has generated has remained stagnant. Dividend payments on the other hand have more than doubled over the same period, which has increased the payout ratio to slightly above 50%. An investment in KMB 20 years ago would be yielding close to 16% on cost. Check out my analysis of Kimberly Clark.

All five stocks are priced attractively at the moment

Full Disclosure: I own shares of PEP, JNJ, PG, MCD, KMB
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