A clean dozen dividend stars

A jittery Europe, a slowing China, and a weak US recovery means rock-solid income is a great choice for investors looking to ride out the storm.

By MoneyShow.com May 10, 2012 2:30PM

Image: Woman reading newspaper in livingroom © Tetra images/Getty ImagesBy the Staff at Briefing.com


Europe remains a major global macroeconomic headache. Yet, many investors who are risk-averse have become overly cautious towards the U.S. equity market.


There are, however, excellent investment opportunities in high-quality, high-yield dividend stocks.


The S&P 500 dividend yield is currently 2.2% on a year-ahead indicated basis. That is a significantly better yield than the 1.88% available on the 10-year Treasury note.


The difference may seem small, but over time it is significant. After 10 years, a 2.2% yield compounds to a 24.3% return. A 1.88% yield compounds to a 20.5% return.


That is only a part of the story, however. A key advantage of dividend-paying stocks is that dividends increase over time while the coupon on a Treasury note remains unchanged throughout the entire term of the note. This can make a big difference in total returns.


Assume that a company that pays a 2.2% dividend increases its dividend 7% per year. The total return on the original investment now rises to 34.9%. The return on the dividend investment of 34.9%, compared to the 20.5% return on the Treasury yield, means that stocks provided over 70% more income during that period.


Dividend increases are an important part of long-term investing in high-quality stocks. And dividend increases are picking up.


Dividend hikes up sharply
Since the beginning of the year, 152 of the 500 companies in the S&P 500 index have raised dividends. That is up from 137 companies in the January to April period last year, which is up from just 95 over the same period in 2010 and just 68 over that period in 2009.


The increases for a lot of companies have been substantial, yet the payout ratio (dividends/profits) for the S&P in aggregate remains near the lowest level in over 100 years. That means that there is plenty of room for further dividend increases in the years ahead.


Eight months ago, we took a look at the value in dividend plays and listed seven stocks that have increased their dividends each year for 29 to 55 years. Each of these companies has increased its dividend in 2012, as noted in the table below (the McDonald's increase was in late 2011). The current yield is listed, as well as the yield for those who purchased the stock at that time.


Stock      Current Dividend Yield        Dividend % Increase           Yield from Sept. 12 Purchase
3M (MMM)                          2.7%                       7.3%                        3.0% 
Abbott Labs (ABT)              3.3%                      6.3%                        4.0% 
Coca-Cola (KO)                  2.7%                      8.5%                        2.9% 
Exxon (XOM)                      2.7%                      21.3%                      3.2% 
McDonald's (MCD)              2.9%                     14.8%                      3.2% 
Procter & Gamble (PG)      3.5%                      7.1%                       3.6%
Wal-Mart (WMT)                 2.7%                      8.9%                       3.1%


Investors should look not just at the current dividend, but recognize that the rising dividend over time makes a major difference.


Consider Coca-Cola. The dividend increase has been 24% over the past three years. Assuming a similar increase the next three years, an investor will be receiving a yield of 3.29% on his/her original investment, compared to the 2.65% currently listed. Dividend increases can make a huge difference.


Below is a projected return on current investment in three years for selected companies that have a history of raising dividends significantly.


Stock                                      Current Yield         Projected Div. Increase   Yield in 3 Yrs
Johnson & Johnson (JNJ)                  3.8%                       7%                              4.7%
3M (MMM)                                          2.7%                       7%                              3.3%
Wal-Mart (WMT)                                2.7%                      10%                             3.7%


Another advantage of high-quality, high-dividend yield stocks for risk-averse investors is the relative stability offered by these stocks. The stability results from the fact that a decline in share price results in a higher yield. That entices buyers.


If the decline in the stock price is due to macroeconomic issues (such as fears about Europe) rather than company-specific issues, the higher yield on these stocks will probably also occur while Treasury yields drop. These stocks will generally have lower volatility than the market overall.


A collection of high-quality, high-yield stocks provides diversification that reduces the impact of market volatility even further. For instance, a diversified portfolio of high-quality, high-yield stocks doesn't have to ignore the tech sector anymore. Here are some top-quality tech names that pay outstanding dividends, have low payout ratios, and have increased dividends in recent years.


Stock                      Current Yield                         Payout Ratio                 12-mo Dividend Rise
Apple (AAPL)                1.9%                                       26%                        n/a
Cisco (CSCO)               1.7%                                       17%                        33%
Intel (INTC)                  3.0%                                       35%                       16%
Microsoft (MSFT)          2.6%                                       27%                        25%


All of these companies have good yields, and are likely to raise dividends in the years ahead. Technology companies can be part of a high-quality, high-yield equity approach.


Financial stocks, however, present a separate set of issues. There is tremendous upside potential for dividend increases by financial companies. Bank of America (BAC), for example, may very well be paying a large dividend in two years.


There is far greater risk, however, in expecting financial company dividends to rise in the years ahead compared to other sectors. Financials are subject to continuing pressure from credit market conditions and regulatory constraints. Financial stocks have a higher reward potential, but also greater risk than most high-yield dividend stocks, and may not fit the strategic approach desired by risk-averse investors.


What it all means

Even risk-averse investors can participate in the upside offered in equities by focusing on high-quality, high-yield dividend stocks. It isn't an exciting strategy, and it will underperform if the stock market rises dramatically.


Over the long term, however, it is a strategy that is likely to outperform simple investments in high-yield debt instruments, due in part to rising dividends, and due in part to potential increases in stock prices. It is also highly likely to outperform cash, even with the downside risk in equities.


Europe is in turmoil, but U.S. corporate cash flow is very strong. That has led to an acceleration in dividend increases that is likely to continue in the immediate years ahead.


Current high dividend yields in selected stocks coupled with the prospect of strong dividend increases in the years ahead present excellent investment opportunities for risk-averse, long-term investors.


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