Financial advisers increasingly are looking to dividend income as a means to provide cash flow to retired clients — despite some obvious risks in doing so.
Interest income has disappeared for investors as rates stay near zero, with no indication that they will go up anytime soon. Dividend advocates note that yields from stocks have held up — and even grown.
DOUBLE-DIGIT YIELD GAINS
In fact, dividend increases for U.S. stocks should be up about 10% this year, on top of a 10% gain last year, said Jeremy Schwartz, director of research at WisdomTree Asset Management Inc.
Dividends are “the name of the game now” for clients, said Bill Ring, president of Security Capital Portfolio Management Inc.
“The old 40% bond, 60% stocks [allocation] with generationally low interest rates scares the hell out of me,” said Mr. Ring, who manages about $14 million for clients.
Among his favorite income generators are the Alerian MLP ETF (AMLP) and the SteelPath MLP Income Fund (MLPDX), which hold individual energy-related master limited partnerships.
With a 3.5% inflation rate, shorter-term, high-quality fixed-income instruments are losing value, said Vern Sumnicht, president of Sumnicht & Associates LLC.
“Dividend yields are up there — you can get 3% or 3.5% in a diversified portfolio of pretty good stuff, which is a way to maintain purchasing power with the potential to go higher,” he said.
Mr. Sumnicht, who manages about $400 million, overallocates to value stocks with growing yields, using the Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Dividend ETF (SDY). Both screen for stocks with long records of increasing dividends.
High-dividend-paying sectors such as consumer staples and utilities have been performing well this year, perhaps driven by growing interest among investors and advisers, observers said.
And still more advisers may boost allocations to dividend-paying stocks, said Josh Peters, editor of the Morningstar DividendInvestor newsletter.
Instead of relying on an asset allocation plan and re-balancing to raise cash, advisers are putting more emphasis on steady dividend payers and measuring success against a client income benchmark, he said.
SUSTAINABLE INCOME
“They need to be thinking about sustainable income from their [client] portfolios,” Mr. Peters said.
Obviously, a shift from bonds to stocks can increase risks in a portfolio. Although dividend payers tend to be more stable than the market as a whole, any stock investment must still be considered long-term, analysts contend.
Analysts especially warn in- vestors of falling into the “yield trap,” where they grab for an unsustainably high dividend. Indeed, a number of research papers have shown that the very top dividend-paying companies are some of the riskiest, because this group includes troubled companies that can't sustain high payouts.
Most recently, a study by Heartland Advisors confirmed this. It looked at returns from U.S. stocks from 1928 through 2010, and found that the highest-yielding stocks performed worse than the next highest-yielding group.
For this second-place group, the median annualized 20-year return was 13.75%, beating all other groups — dividend payers and non-payers alike — for both return and risk-adjusted performance.
Earlier studies over shorter historical periods conducted by Credit Suisse Group AG and Bank of America Merrill Lynch found a similar pattern — the highest yields produced lower returns, while the next-highest groups were the most promising investments.
“Certainly high-single-digit or low-double-digit yields are oftentimes a red flag that there's trouble at a company, or shows a high likelihood they could cut the dividend,” said Adam Peck, portfolio manager of the Heartland Value Plus Fund (HRVIX).
Dividend yields in today's market of 3% to 6% “is where you want to concentrate,” Mr. Peters said.
Analysts check for earnings and especially cash flow coverage of the dividend, with plenty of room for error.
SAFER THAN BONDS
Risks of stocks aside, many advisers see more danger in extending bond durations or taking more credit risk to boost yields.
After a 30-year bull run, bond “prices are at absolute peak levels,” Mr. Schwartz said.
At the same time, advisers now have more places to shop for dividends. Observers expect the maturing, cash-rich tech sector to initiate more dividend payouts, for example.
Last year, among U.S. large-caps, technology stocks for the first time paid out more in dividends than financial stocks, Mr. Schwartz said.
“Microsoft [Corp.] has been kind of the [technology] canary in the coal mine on this,” Mr. Peters said.
“Cisco [Systems Inc.] is the poster child for ineffectual share buybacks,” Mr. Peters added, but in April, it initiated its first cash dividend.
Tech stars such as Apple Inc. and Google Inc. also could start paying dividends, with no ill effects on their growth, analysts said.
And don't overlook small-caps.
“Where we look [for stocks] with market capitalizations of from $250 million to $4 billion, around 800 [companies] pay a dividend” out of a universe of about 3,000, Mr. Peck said.
“One of my very favorite companies is Realty Income Corp. (O), which is not a very large company, but their whole reason to exist is to pay a monthly dividend,” Mr. Peters said. Auto parts distributor Genuine Parts Co. (GPC) is another midcap company with a history of increasing dividends, Mr. Peters said.
Many more U.S. companies could pay heftier dividends, observers said.
From the end of World War II through the early 1990s, the percentage of earnings paid out as dividends for the S&P 500 stocks averaged 50% to 55%, Mr. Peters said.
“The [earnings] payout ratio will be at 27% this year, a record low, and essentially half of the old norm,” he said.
Mr. Peters expects that non- dividend-paying companies will suffer valuation discounts as investors demand more income.
Until then, the good news is that big-cap consumer stalwarts such as Johnson & Johnson (JNJ) and Procter & Gamble Co. (PG), and a host of utilities, will pay “generous dividends and continue to grow them,” Mr. Peters added.
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