It’s a smart move to invest in dividend-paying stocks

  • Stocks that pay dividends have, over long periods, outperformed stocks that do not.
  • Dividend-paying stocks are often less volatile because they have less "duration," or interest-rate sensitivity.
  • If the long-term return expectation for equities is in the high single digits, why not ask for the majority of that return up front?

Today's headlines are as unnerving as ever, but so far this year, neither natural disasters nor geopolitical events have had more than a temporary influence on financial markets. The new all-time highs being reached by global stocks, however, rest on valuations that are rich by historical standards.

Those valuations are in turn supported by ultra-low interest rates, courtesy of the world's central banks, which are now looking to engineer a more "normal" interest-rate environment. Many fund managers are raising cash and buying protection, worried the market's buoyancy and remarkable lack of volatility will be tested.

Stocks that pay dividends have, over long periods, outperformed stocks that do not.
GlobalStock | Getty Images
Stocks that pay dividends have, over long periods, outperformed stocks that do not.

We know that equity exposure is important for long-term growth, but how should investors be positioned for an equity environment that in all likelihood will be more volatile than in the recent past?

One approach in uncertain times is to insist on payment up front — in other words, to invest in stocks that provide sustainable and growing dividends. Stocks that pay dividends have, over long periods, outperformed stocks that do not. Returns from stocks that grow dividends tend to be better still. And in our experience, these stocks have substantially less volatility than the broader market, helping to protect capital during market downturns.

Why are dividend-paying stocks less volatile?

To begin with the obvious, the dividend portion of their total return is paid to you in cash. Regardless of how a stock's price fluctuates from there, you are starting out with the cushion of a positive return. Furthermore, a growing dividend usually reflects growing free cash flow from the underlying business. Companies that pay and grow dividends tend to be mature and well established, with the ability to withstand economic downturns and steadily grow their business across business cycles.

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If a company is growing dividends but not growing cash flows, it is liquidating. And we do mean cash and not earnings. Cash is what matters. Companies are run on cash. Earnings, on the other hand, are shaped by the vagaries of accounting. A host of issues, from the treatment of inventories to the rate at which capital assets are depreciated, can lead to positive earnings while cash flow is negative, or negative earnings while cash flow is positive.

Another reason dividend-paying stocks are often less volatile is that they have less "duration," or interest-rate sensitivity, than stocks that pay no dividend. We know that as rates rise, the prices of longer-duration instruments fall faster than the prices of shorter-duration instruments (assuming all else being equal). While the concept of duration is thought to be primarily applicable to fixed-income assets, equities also have this characteristic. Just like bonds, the more cash paid sooner, the lower the duration. A stock that provides a healthy dividend is essentially a "shorter-duration" equity than a "growth stock" that has a very low or no dividend payout.

Another important concept is that, in our view, investors should think more broadly about the ways companies can return cash to their owners. Cash dividends, which we have discussed, are the most obvious means. And a long track record of regular, growing dividends speaks volumes about a company's stability and the priorities and shareholder orientation of its management. But buying back shares and paying down debt are also legitimate ways to return cash, as both provide shareholders with a larger claim on future cash flows. Collectively, dividends, share buybacks and debt pay-downs are known as shareholder yield.

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Shareholder yield is the proverbial bird in the hand. If the long-term return expectation for equities is in the high single digits, why not ask for the majority of that return up front? We may not know if the market is overvalued or undervalued, or if the mood will be risk-on or risk-off, but we do know that if you make shareholder yield your main source of return, you will get paid.

Here are some examples of stocks that will play well when it comes to shareholder yield and which we recommend to investors.

Red Electrica

Dividend Yield: 3.9 percent (as of 9/30/2017)

Red Electrica is a Spanish regulated utility that owns and operates the country's electricity transmission network. It also has small exposures to regulated transmission operations in Peru and Chile and is involved in the management and leasing of fiber-optic networks to telecommunications companies in Spain. The regulatory framework in Spain offers an attractive allowed return that encourages investment in the country's energy infrastructure.

Its investment in the expansion and improvement of the transmission systems and in its regulated asset bases drives its rate-base and cash-flow growth. In addition, operating and financial efficiency improvements are expected to lead to margin expansion and sustainable cash-flow growth. Red Electrica consistently rewards its shareholders with an attractive dividend. With stable regulation in Spain, the company is expected to grow its dividend at 7 percent CAGR through 2019.

Altria Group

Dividend Yield: 3.9 percent (as of 9/30/2017)

Altria is the largest U.S. tobacco company and manufacturer of the top-selling brand in the United States: Marlboro. Altria's tobacco portfolio includes cigarettes, smokeless tobacco and machine-made large cigars. Altria also has a wine business and a stake in Anheuser-Busch InBev. Consistent cash flows are driven by a combination of top-line growth, disciplined cost management and a solid balance sheet. The pricing power of the tobacco industry allows for predictable revenue generation despite volume pressure.

Altria continues to maximize income while balancing market share with the help of strong brands, innovative tobacco products and a diverse income stream. High margins and relatively low capital expenditures further enhance Altria's ability to generate attractive, sustainable cash flows.

With an 80 percent dividend payout ratio, management remains committed to returning a substantial amount of cash to shareholders each year through their dividend. Management also intends to repurchase stock during the year.

— By Kera Van Valen, portfolio manager at Epoch Investment Partners

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