Wednesday, June 1, 2011

Dividend Investing in a Low Interest Rate Environment

Yields on fixed income instruments have been in a decline over the past 30 years. While yields on long term obligations were in the mid to high teens in the early 1980’s due to higher inflation, they have come down quite a bit in the early 2010’s to some of the lowest levels in US history. As a result certain cash deposits such as Certificates of Deposits or Treasury Bills yield less than half a percent. Investors putting cash in any short-term fixed income instruments are not earning an adequate return on their investment and are also losing purchasing power of their savings because of inflation. As a result many savers have started taking on additional risk and getting into dividend paying stocks.

Investing in companies that pay dividends could be rewarding, since it could lead to a rising stream of dividend income, which bonds cannot provide. In addition to that, a portfolio of carefully chosen dividend companies might provide an inflation hedge, as companies pass on rising prices to consumers, which leads to increases in profits and dividends.

The main disadvantage behind investing in dividend stocks however is that your investment is not guaranteed by the FDIC, and could lose some or all of its value. In addition to that, unlike most bonds, dividends are not guaranteed and can be cut. Savers could still earn an adequate amount of interest by purchasing long-term bonds, but even if inflation is modest over the next few decades, it could leads to much lower real returns.

Investors who want to generate a rising stream of income that protects their principal and income from inflation should consider carefully selected dividend stocks. The first place to look is at companies which have a history of raising distributions for at least one decade. Companies which can do this are typically stable and mature businesses, which generate a sufficient amount of cash to expand and share the excess with shareholders in the form of dividends and share buybacks. Once management has committed to consistently raising distributions year in and year out they tend to be more conservative with cash and take only projects that have a higher chance of not only earning money but also earning a sufficient return on investment. Such management knows that cutting distributions would make shareholders unhappy, and would only do so if the business is in trouble.

Another thing that investors should look for is strong competitive advantages. Wal-Mart (WMT) is the largest retailer in the US, operating over 4000 stores domestically. Due to its sheer scale, the company could obtain favorable deals for merchandise and could generate efficiencies that lead to lower costs than competitors. Colgate Palmolive (CL) on the other hand produces quality brand consumer products such as toothpaste, which consumers have to buy in any economic environment. Procter & Gamble’s (PG) Gillette product line is another type of a strong brand which consumers are attached to and prefer to purchase over generic substitutes. As a result companies like Colgate (CL) and Procter& Gamble (PG) have strong competitive advantages in their respective areas.

Another quality to look for in dividend stocks is a business model which is relatively recession resistant. Even during recessions consumers still need to purchase groceries at low cost stores like Wal-Mart (WMT). Consumers still need to use shaving products from companies such as Procter & Gamble (PG), and they still need to brush their teeth with toothpaste from companies such as Colgate Palmolive (CL). The strong competitive advantages, combines with high returns on equity and relative immunity from recessions generates stability in earnings which translates in stable distributions.

The greatest dividend stocks not only have stable earnings however, but they also tend to increase profits over time through innovation, acquisitions and process improvements. A rising earnings pattern could translate in rising dividend incomes over time. This provides the necessary cushion that would protect your dividend income against inflation. Rising earnings also should translate in rising stock prices, which also bodes well for preserving the purchasing power of your principal.

Last but not least investors should only purchase companies which have a sustainable dividend payment and stocks which are not overvalued. When I see companies which pay out in dividends more than what they get in earnings, this automatically raises a red flag. Spending more than what you earn is rarely a sustainable business model for the future. Investors should look for companies which have obtained a proper balance between the amount of earnings they reinvest and the amount of earnings they distribute to shareholders. In addition, overpaying for stocks could lead to subpar returns over time, even if the business itself performs very well.

Full Disclosure: Long CL, PG, WMT

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