Shaping a Portfolio–Dividend-paying Stocks

A Traditional Way of Allocating Assets

One traditional technique for individual investors to allocate assets is to establish a cash reserve and then allocate enough money to government bonds or other fixed income that interest payments will cover living expenses.  Any remaining money would go into riskier assets, like stocks.

The idea is that the bonds provide a reliable, regular stream of income.  They are subject to two risks, though, assuming you hold to maturity: inflation may erode the purchasing power of interest and principal; and the principal must be reinvested at the end of the term of the bonds.  The stocks, on the other hand, may not provide much income but, because they are ownership interests in corporations strong enough to be publicly traded, they provide superior growth potential as well as some protection against inflation.

How Today Differs

Today, for the first time since the Great Depression and the years immediately after World War II, we are in the unusual position that stocks provide pretty much the same income as government bonds.  Even after the market advance since the early-March lows, and factoring in the dividend cuts by financial companies, the dividend yield on the S&P 500 is still about 2.5%.  If we consider only dividend-paying stocks in the S&P 500, the average yield is about 3.25%.  This compares with the 10-year Treasury bond, which yields 2.87% and the 30-year, which yields about 3.75%.

Unlike bond interest, there is the possibility that dividend payments can rise.  And because the Fed has responded to a horrible economy by temporarily lowering short-term rates to effectively zero, we are arguably at a high point for fixed income.  This, at a time when we are also, arguably, at a low point for stocks.

Unlike a few weeks ago, it may not be possible today to match the yield on the 30-year bond without reaching into the riskiest end of hte S&P 500.  But stocks like MMM, PG or INTC all yield about 3.5%, well above the 10-year bond.  Yes, these are mature companies that may not produce sizzling capital gains.  But if the dividends are secure, they seem to me to be a better choice than treasuries.

What about corporate bonds instead?  Yields here are much higher than treasuries.  (Remember, in reading what follows, that I’m a stock person, not a bond person).  Yes, that’s true and there is also some overlap between the riskiest end of the S&P 500 and investment-grade corporate issuers.  But I think the overall riskiness of the issuers of corporate debt, especially below investment grade (“junk” or “high-yield”), is substantially higher than for the S&P, and the instruments are substantially less liquid.  So you really better know what you’re doing in this arena.

What Could Go Wrong

What do I think could go wrong with buying 3.5%-4% dividend yield stocks?  Three points:

1.  The worst case is that operating weakness may force the company to reduce, or even eliminate, the dividend.  Dividends are supposed to be paid out of profits.  Also, the money may be needed to repay debt or to fund the operation of the business.  But you can do homework to see if this is a reasonable possibility.  Analyzing the flow of funds is the best approach.  But you can also check with services like Value Line for their statistics on how well covered the dividend is.  By the way, this is the issue with ultra-high dividends–the market is saying it doesn’t believe the payout is sustainable.

2.  The total return on a higher-than-average dividend stock may be below that of the market.  If we assume there’s no free lunch, then there’s a price to be paid for straying from the combination of dividend and cpaital change that the index is presently offering.  For the first extra unit of dividend, you may have to only give up one unit of chapital appreciation.  For the second, you may have to give up 1.2 units, and so on.  This may not matter to you.  But what I think is the most interesting aspect of today;s situation is that you don’t drift far from the market yield to do better than a 10-year bond.

3.  This one is a little bit out of left field.  I’m not sure how serious a worry it is.  As I’ve written elsewhere, it’s been more than twenty years since dividends have been close to 3% on the S&P 500 (this may be another way of saying it’s been that long since stocks have been so weak).  In any event, having a large dividend yield hasn’t seemed to me to have provided any cushion at all against a stock’s fall.  That could be changing, on the way back up.  But if company directors get it into their heads that dividends are a stock attribute that investors don’t want, sort of like huge tail fins on a car, then they may begin to think the payout could be better used by the company elsewhere and cut the dividend even though they don’t need to.

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