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Dividend Stocks: A Great Investment Strategy For Bad Times
Tuesday, October 21, 2008: Issue #568
by Martin Denholm, Managing Editor, Smart Profits Report
You can get more than one sound investment strategy from watching - or playing - sports.
One of the truest rules is also one of the most fundamental: If you want to be successful through the bad times as well as the good, it starts with playing solid defense.
Sadly, this is a concept lost on my favorite English soccer team, Everton, who’ve shipped a league-high 18 goals in just eight games this season. It’s also lost on the Denver Broncos, whose defense has more holes than the Old Course at St. Andrews and who got walloped 41-7 by New England on Monday night.
And, it seems to be lost on the majority of investors right now as well.
When it comes to any kind of investing strategy, the ability to play solid defense can ease you through turbulent times much better than most ordinary investors. And the concept here is simple: Defensive investing means having some strong, dividend stocks in your portfolio.
A 72-Year History Of Top Performance
The two main concepts that dominate the stock market climate are fear and greed. While they’re always prevalent, investors with a strong investment strategy know better than to base their decisions on fluctuating sentiments like these.
Instead, it’s better to look for long-term drivers - like earnings growth, cash, and the ability of companies to pay dividends to their shareholders.
History shows that the latter is a particularly smart way to go. From 1935 to 2007, more than 40% of the S&P 500’s total return came from reinvested dividends.
The beauty of dividend stocks is that they work well in both rising and falling markets. SensibleStocks.com reports that during the bull market of 1982 to 2000, dividend stocks actually outperformed non-dividend payers by a considerable margin, despite the underlying share price appreciation.
And during the bad times involving the volatile, sinking markets we’re experiencing now, it’s comforting to know that you’ve still got a source of income throughout the madness. You’re essentially being paid for your patience, rather than selling off like everyone else.
Let’s look at some more benefits…
3 Reasons To Invest In Dividend Stocks
Dividend stocks offer more than one compelling reason to invite them into your portfolio. Here are the three best ones:
- Lowers Cost: When you’re picking up a regular dividend payment per share every quarter, over time, it reduces the price you originally paid for the shares. It’s essentially like buying a house, then renting it out to offset the payment and pick up income, while the underlying asset appreciates at the same time. And of course, since the Jobs Growth and Tax Relief Reconciliation Act of 2003, investors have paid lower taxes on dividends.
- Provides Stability During Downturns: When the broader stock market is under pressure and share prices are falling, dividend stocks are often considered one of the “safer haven” investment strategies out there, since investors are still receiving income. In turn, it’s good PR for a company, with the stock attracting more investors and the share price potentially rising as a result. Pay attention to the level of insider ownership of a stock here. This is not a hard and fast rule, but if insiders hold a big chunk of the company themselves, they’re less likely to be reckless with its money through overly ambitious projects or ill-advised buyouts, and may well pay greater attention to shareholder interests and dividends.
- Keeps Management In Line: When an executive team is dishing money back to its shareholders, not only does it show sound business acumen to be able to do that in the first place, but it also keeps them honest. Knowing that they have to make good on didvidend payments on a regular schedule reduces the chances that they’ll fritter your money away on wasteful projects. And as we’ve come to learn in a particularly painful fashion, that’s a very good thing.
Of course, there are pitfalls, too. So before I get to a couple of investment options for you, let’s look at those…
Dividend Stock Drawbacks
Dividend Stocks do have their drawbacks of course, as with everything else in life, so it’s important to look at every angle of a company before you jump into any particular company just because they offer them.
- Dividend Reduction Or Suspension: At a time when obtaining credit is tighter than ever before, it’s much more likely that companies will reduce or suspend their dividend payments. This is usually a last resort, as it signals to the world that the company is having trouble raising cash, which can, in turn, severely impact its share price.
- Twice The Tax… And Higher In 2010? Naturally, the IRS needs to grab its piece of the pie - and when it comes to payments from dividend stocks, it’s a double-whammy. First, it claims the regular corporation taxes from the company. Then, when the company passes what’s left down to its shareholders, those investors are then taxed on what they receive. In addition, the Jobs Growth and Tax Relief Reconciliation Act that I mentioned a moment ago expires in 2010, so we may see dividend taxes rise when it does.
- Lack Of Investment Options: Some argue that while companies should be praised for rewarding shareholder loyalty through dividends, it may also mean that it can’t find other investment options, or projects that would accelerate the company’s growth.
And beware companies that offer sky-high dividend yields. It could merely be a crafty way to mask bigger problems. Automakers like General Motors (NYSE: GM) and Ford (NYSE: F) are good examples, as are some of the beaten-up financial stocks like Citigroup (NYSE: C).
In addition, as share prices drop, dividend yields rise, which can be a false dawn. Bottom line: If a company isn’t growing its earnings or its cash-flow has shrunk, it may well be a bad sign. Make sure you do your regular due diligence.
Where To Look For The Best Dividend Stocks
Right now, two of the best sectors to find dividend stocks are Consumer Staples and Telecom.
In the upcoming November Xcelerated Profits Report issue, my colleague Jim Stanton is recommending one of the best companies within the Consumer Staples sector, which pays a dividend. One of the advantages that this sector has during a downturn or recession is that it continues to generate revenue through essential repeat business. After all, consumers always need everyday household items.
(As an aside, you can get your hands on Jim’s specific Consumer Staples recommendation by signing up for the Xcelerated Profits Report. Just click this link for more details).
In the telecom sector, firms like Verizon (NYSE: VZ) and AT & T (NYSE: T) boast some rock-solid financials, allowing them to pay a 6.8% dividend ($1.84 per share annually) and 6.3% ($1.60 per share annually).
In the current climate, though, if you don’t want to take the chance on individual companies, you can always diversify and lower your risk by buying ETFs that hold companies offering dividend stock choices. Take a look at…
SPDR S&P Dividend ETF (SDY: AMEX): Holding stocks like Bank of America (NYSE: BAC), Pfizer (NYSE: PFE), Fifth Third Bancorp (Nasdaq: FITB) and Consolidated Edison Inc (NYSE: ED), the fund tracks the price and yield performance of stocks in the S&P High Dividend Aristocrats index.
PowerShares High Yield Dividend Achievers (AMEX: PEY): This fund’s results try to correspond to the Dividend Achievers 50 Index. Around 80% of its holdings are in companies that have consistently raised their dividends. Its holdings include Bank of America, Keycorp (NYSE: KEY), American Capital Strategies (Nasdaq: ACAS), BB&T Corp (NYSE: BBT) and Comerica (NYSE: CMA).
Best regards,
Martin Denholm
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[...] mess, many pundits have touted the benefits of dividend paying stocks. It’s an issue we wrote about here a couple of weeks [...]