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Dividend Paying Stocks Help Protect Capital in This Uncertain Market

Posted November 6, 2009

Topics: Finance & Investing

These are highly unusual times. The stock market seems vulnerable following the more than 50% resurgence since early March. While Fed liquidity and heavy amounts of cash on the sidelines--combined with low interest rates--are providing solid underpinning to the market, the numerous cross currents are gaining gravity and may eventually drag the stock market lower. I hardly need to reiterate the serious issues on the horizon--rising unemployment, bulging multi-trillion dollar federal deficits, the worst deflation since the Depression, curtailed consumer spending, depressed home prices and surging foreclosures, extensive consumer and government debt levels, frozen credit, essentially no economic growth, coming higher taxes, the falling dollar, maxed out corporate earnings, and reeling commercial real estate. These burdens are likely to weigh down the stock market at some point, especially given the current exalted valuation levels.

The most critical investment strategy that I emphasize in my book Full of Bull is preservation of capital. Sure, it’s easy to protect capital if you are out of the stock market, but if you are a normal investor you may need the dividend income or want to hold stocks long term and avoid taking capital gains. So if you hold stocks during this vulnerable period, I strongly advocate that they carry hefty, reliable dividend streams.

A safe dividend provides some downside protection during a setback. A $20 stock that pays an $0.80 dividend (a 4% yield) is unlikely to plummet to $8 (which would be a 10% yield) unless the firm is about to slash the dividend payout. The downside is more likely to be $13 to $15; that is, a 5% or 6% yield. Dividends might play an even more important role in the future if the market gains ease to 5% to 8% or worse. Jeremy Siegel, a professor at Wharton, illustrates the importance of dividends with a striking example: From 1950 to 2003, IBM’s revenues, earnings, and dividends climbed faster than those of ExxonMobil. The oil company paid a healthy dividend during the entire span, while IBM started its payout much later and at a lower level. Equal investments in both stocks in 1950 with all dividends reinvested through 2003 would have resulted in a 24% better total return from Exxon.

Moreover, there is a direct positive correlation between dividend payout ratios and earnings growth as found in studies like the one by Robert D. Arnott, editor of the Financial Analysts Journal. The higher the payout, the faster the earnings pace. This startling relationship probably indicates that managements paying out higher dividends have confidence in bright future earnings growth prospects. And dividend yield is a key indicator of financial stability, good cash flow, and quality earnings. Dividends reduce excess cash on hand, forcing executives to be careful and make wise decisions in picking new investment projects.

There is no reason for companies not to pay out 50% of their profits. But many managements are afraid that investors might misinterpret this as a sign of maturity and an inability to reinvest in the growth of the business. Instead they use cash to repurchase shares, and this often drags down returns. During the 1990s bubble years, dividends were neglected; companies paying them were considered dodo birds. Then after the Internet bubble burst, and the 2000–2002 bear market ensued, yield came back into vogue. From 1926 to 2006, the total stock market return averaged close to 11% annually, and 41% of this, or 4.4% of the gain each year, stemmed from dividends, according to the Motley Fool Income Investor. From 1999 to 2008, the stock market declined some 40%, but dividends, when reinvested, offset almost the entire drop.

Astonishingly, dividend paying stocks also outperform non-payers in bull markets. The Motley Fool observed that from 1980 to 2005, while the S&P 500 surged from around 100 to 1250, dividend stocks outgained non-dividend equities by more than 2.6 percentage points a year, much of the difference stemming from superior stock price performance.

My second most important investment thesis is to focus on value stocks. This is another method by which to help protect your capital during a falling market, to be discussed in a future blog. But my point here is that a dividend paying stock is almost always a value stock. Most likely, if a company is paying a healthy dividend of a 3%-6% yield, it is a value stock. When investors ask me to define “value,” the first thing I look for is the yield. Dividends are key during times like this and, for that matter, in any stock market. If your stocks are not paying dividends, you are not only more vulnerable to downside volatility, you are also missing 41% of the potential return on your investment over the long term.