Wednesday, June 16, 2010

Five Dividend Stocks which beat Index Funds

Many dividend investors pick stocks simply for their yield. This could be detrimental to investment returns, since most high yielding stocks are concentrated in few sectors and distribute almost all of their earnings. This leaves the dividend payment exposed to fluctuations in operating performance. Most successful dividend investors on the other hand tend to focus on companies that have solid fundamentals. Only such companies can afford to raise dividends consistently over the long run. Despite the importance of dividends however, investors should not forget about capital gains are important as well, particularly because they provide the other 50%-60% of annual total returns. The beauty of dividends is that they are always positive; they don't fluctuate as much as the price returns, and as such present a somewhat more stable source of income.The truth is that dividend investors also diversify across the ten major sectors, and also geographies, continents, industries etc. Academic studies cite that company specific risk is reduced substantially in a diversified portfolio consisting of 30-40 securities from different sectors of market. Thus a portfolio of 30 companies should perform similarly to the returns of S&P 500 (the market). If you compared the returns of Dow Jones Industrials Average, which is a subjectively selected portfolio of 30 stocks, you would notice its returns are close to that of S&P 500. The latter has 470 stocks more than the Dow Industrials Average. As a result, investors do not need to own more than 30 or 40 individual stocks, in order to generate market like returns.

There are several issues with indexing; some of it stemming from the fact that decisions affecting inclusion of firms are not made in accordance with a consistent strategy in mind. Back at the top of the internet bubble, many tech companies were added at inflated prices, only to be removed when prices were at their lows. This excessive turnover lowers portfolio returns. In fact, if the S&P 500 never added or removed any of its original components, it would have outperformed the results of the S&P 500 over the past 50 years.

Another problem with indexing is that there is too much turnover, and also there are management fees of 0.10% annually even for the lowest cost mutual fund. If your portfolio is $100K, that's $100/annually out of the door. Currently there are many brokerages offering free trades, which would essentially lower investment costs to zero. For example last year I paid $0 in commissions. So far this year I have also paid $0 in commissions. Thus I get to keep my $100/ annually while I am also statistically close to at least matching market returns. Another issue with index funds is that the top 30 firms in the S&P 500 account for 40% of its returns.

As a result, it seems that less than 6% of the companies included account for the majority of returns over time. This proves that a diversified dividend portfolio, which has a proper allocation to as many sectors appropriate would do equally well relative to the S&P 500 index over time. One such portfolio includes the S&P Dividend Aristocrats index, a well diversified index of companies which have raised distributions for 25 consecutive years, which has outperformed the S&P 500 over the past decade.

Dividend investors do not have to be successful stock pickers, in order to be perform well over time. They just need to learn where to find the best dividend growth stocks – either in the Dividend Aristocrats Index or in the Dividend Achievers index. Next, they need to open a low cost brokerage account and start building a well diversified portfolio over time.

In addition to that, dividend stocks have provided superior returns among S&P 500 companies according to Ned Davis Research. One hundred dollars invested in non dividend payers of the S&P 500 in 1972 would have underperformed $100 invested in dividend payers during the same timeframe.

Some of the companies with the highest weights in the S&P 500, which also happen to be some of the best dividend stocks in the world include:

Johnson & Johnson (JNJ) is engaged in the research and development, manufacture and sale of a range of products in the healthcare field. Johnson & Johnson owns more than 250 operating companies under 3 segments – Consumer, Pharmaceutical as well as Medical Devices and Diagnostics. Johnson & Johnson has increased its dividend for forty-eight consecutive years. This dividend aristocrat has a ten year distribution growth rate of 13.30% per year. Check my analysis of the stock. Yield: 3.60%

The Procter & Gamble Company (PG) is focused on providing branded consumer packaged goods. The Company’s products are sold in over 180 countries worldwide primarily through mass merchandisers, grocery stores, membership club stores, drug stores and in high-frequency stores, the neighborhood stores, which serve consumers in developing markets. The Company was organized into three Global Business Units: Beauty; Health and Well-Being, and Household Care. Procter & Gamble has increased its dividend for fifty-four consecutive years. This dividend aristocrat has a ten year dividend growth rate of 10.70% per year. Check my analysis of the stock. Yield: 3.10%

Chevron Corporation (CVX) manages its investments in subsidiaries and affiliates, and provides administrative, financial, management and technology support to United States and international subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining operations, power generation and energy services. This dividend achiever has managed to boost distributions for 23 consecutive years. Check my analysis of the stock. Yield: 3.90%

The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. Coca Cola has increased dividends for 48 consecutive years. This dividend aristocrat has a ten year distribution growth rate of 10.00% per year. Check my analysis of the stock. Yield: 3.30%

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The world’s largest retailer has a 36 year record of annual dividend raises. I would be a buyer of WMT on dips. Check my analysis of the stock. Yield: 2.00%

Full Disclosure: Long JNJ, PG, KO, CVX, WMT

This article was featured on Carnival of Personal Finance #263 – Upstate Edition

It was also mentioned by The Financial Blogger in Financial Ramblings

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