Dividends ought to be appealing to many investors even in 2010

Last year, 2009, turned out to be the worst year for investors seeking income from dividend-paying stocks since, get this...1955. That plop in income translated to a 21 percent decline in dividends per share for the stocks in the S&P 500. Even so, a dividend is a dividend. And even though some have projected that dividend yields aren't expected to return to the highs reached in 2008 until 2012-13, income is income.

Eric Lansky is a friend and president of the USAMutuals, a small fund family based in Texas. One of the funds in the familiar that you may be familiar with is The Vice Fund (VICEX). Since I'm like most and not without a vice or two, the concept of the fund is intriguing although its performance could use a little "shaken not stirred" jolt.

Lansky's fund family just released a white paper titled "Attributes of Dividend Paying Companies". The premise behind the report is that the companies The Vice Fund invests in--- namely those in the alcohol, tobacco, gaming and defense industries-- have the potential to generate above average dividends and cash flow and therefore have total returns that could outperform the returns of the market averages.

That could happen, right? And given that something like 40 percent of a stock's total return over the long haul has historically come from dividends, investing in well-established, solid, dividend-paying stocks is a strategy even widows and orphans with or without vices could employ.

That said, be mindful that companies that do pay dividends don't have to keep paying them year-after-year, and, a company may choose to reduce or eliminate dividends payouts at any time.

Back to the report.

Below are a few highlights from the paper that point out some interesting facts and history targeted at dividends and their relationship to total return For instance:

• Stock yields were greater than bond yields from 1926 until 1958. Afterwards, bond yields were higher, and this relationship continued until November 2008, when the yield on the S&P 500 surpassed the yield to maturity of the 10-year Treasury.
• The average dividend payout ratio was around 70% from around 1870 through the mid-1940s before moving closer to 50% the second half of the century, shrinking to near 30% in 2006.
• Dividend yields hit an all time low in 2000 of 1 percent.
• Dividends accounted for more than 40% of the total returns from stocks from 1926 to 1990, but that contribution fell to 17% from 1991 to 2006 as rising valuations during the bull market skewed returns toward capital gains.

The "Attributes of Dividend Paying Companies" is well worth a read. Here it is:

Attributes of Dividend Paying Companies

The Vice Fund (VICEX) focuses on four industry groups - alcohol, tobacco, gaming and defense. The fund manager believes that companies in these sectors have the potential to generate above average dividends and cash flow*, increasing the odds of generating total returns greater than the market averages.

When the S&P 500 Index provided a dividend yield close to 1% in 2000, investing for income may have seemed silly to investors already reaping double digit-capital gains trading tech and telecom companies. Historically, however, dividends and their reinvestment have provided a significant portion of the total returns delivered by common stocks. With stocks offering substantially higher yields today, particularly vs. Treasuries, these same investors may be more interested in building a potential stream of growing dividends than relying on other investors' views of their portfolio holdings (market prices) to help meet their financial goals.

Similarly, investors who have given up on stocks may not realize that a dividend strategy has the potential to generate attractive returns even under conservative assumptions, and even if valuations deteriorate from the date of purchase.

Target price or total return?

A large component of a stock investor's expected return may depend upon what that investor thinks others will pay for that stock in the future. Whether it is a multiple of earnings, cash flow, or enterprise value, many investors associate "return" with capital appreciation only. Certainly a growth stock investor expects any positive earnings to drive the stock price higher. But even if earnings come through as expected, the multiple ultimately paid for those earnings can make the difference between a gain and loss, particularly over shorter periods.

The value investor, on the other hand, searches for a stock that the market has seemingly under-priced, perhaps expecting operations to turn around. If all goes as planned the company's prospects should improve, but the value investor also expects the market to reward the improvement with a higher valuation.

Given the stock market's performance of late, investors are all too aware that perceptions of value can change dramatically. Some investors may find that dividend strategies may somewhat decrease their risk aversion to equities in these volatile environments.

Where do returns come from?

During the bull market of the 2002-2007 it became "common knowledge" that stocks should return around 10% over the "long term." This often quoted figure comes from Dr. Roger Ibbotson's research on asset class returns, and is updated annually in his "Stocks, Bonds, Bills and Inflation." Ibbotson's period for analyzing these returns begins January 1, 1926, and sure enough, stocks have historically delivered returns of around 10% compounded annually, depending on the terminal year selected (for example, 11.1% and 10.4% respectively for the periods beginning Jan. 1, 1926 and ending Dec. 31, 2000, and Dec. 31, 2007).

What is often overlooked when referencing this study is that dividends have historically accounted for more than 40% of long term stock market returns. And because growing earnings (and growing dividends) should ultimately drive stock prices higher, dividends and their reinvestment account for virtually all of long term returns. For example, based on Ibbotson data, a hypothetical $1 invested in stocks on December 31, 1925 would have grown to $2,586 by January 1, 2000, with dividends and their reinvestment delivering $2,483 of that total.1 Sure, a rising PE can drive a stock higher over the short term, but the longer the holding period, the more that dividends, dividend growth, and their reinvestment should account for total return.

As an aside, about 1% of Ibbotson's 10-11% long term annual return comes from price-earnings ratios expanding over the period. In 1926, P-Es were a paltry 10 times earnings and stocks boasted a yield of close to 5%. Since earnings for the entire market grow at a mid-single pace over the long term, clearly it takes either below average valuations or above average PE expansion for the stock market to generate returns well in excess of 10% over several years (for example from 1982-2000).

Potential benefits of compounding

Who could blame investors for being skittish given the volatility of the stock market in recent years? But before abandoning equities completely, investors should consider that long term positive returns could be possible even with conservative assumptions. The accompanying table below hypothetically illustrates how a dividend paying stock could have the potential to deliver returns of 9.54% and 5.38% over 10 years with modest assumptions regarding dividend growth. Note that the valuation of the stock actually falls in Scenario 2 (dividend yields rise - prices fall) and did not change in Scenario 1 (dividend yield remains the same). (Investors interested in the actual performance of dividend oriented portfolios can turn to several academic studies on the subject.)

An investment approach emphasizing dividends may appeal to investors planning for retirement or anticipating a large distribution several years down the road.

For example, the ability of a low yielding portfolio to handle a distribution in year 10 is primarily dependent upon earnings growth and the market's valuation of those earnings (price-earnings multiple) in year 10. A dramatic drop in valuation, such as the 2008 market plunge, could affect the ability of the portfolio to make the distribution while retaining enough equity exposure to create additional wealth.

A portfolio generating more income, however, might handle the distribution without liquidating principal. After all, the portfolio could be designed to generate a positive income stream that grows larger each year, thereby decreasing the risk of forced sales into a weak equity market.

Becoming less dependent on market valuations

The above scenario reminds us that income earned from dividends can work to offset market losses from lower valuations (higher dividend yields). Further, if an investor chooses to reinvest dividends back into equities, lower stock market valuations present the opportunity to add stocks at higher yields, generating even more income. Over time the additional income may offset some or all of the market's lower valuation of equities.

This exercise reminds us of bond immunization strategies that became popular in the late 1970s and early 1980s after rising interest rates decimated the value of bond portfolios. Bond managers discovered they could attempt to provide a client with better assumptions regarding prospective returns once the client defined a time horizon. If during that specified period bond yields were to rise (prices fall), the bond manager (by definition) would be reinvesting coupons at those higher prevailing interest rates. Theoretically, if the duration of the bond portfolio matched the time horizon, by the end of the period the change in the market value of the bonds should be entirely offset by the additional income earned from reinvesting at higher yields (given a slew of yield curve assumptions).

Similarly, a portfolio of stocks with growing dividends might not increase in value for several years. The appreciation component will depend upon what other investors wish to pay for the stocks. But the income generated will be determined by the dividend yield when the portfolio is structured, how fast dividends grow, and how those dividends are reinvested. If given a chance to compound long enough, the growing income stream could potentially generate a positive compound annual return even in the face of severe market losses. Note, in the above scenario, if we assume a payout ratio of 40%, the price-earnings multiple in Scenario 1 fell from 13 to 8, yet the investor generated a positive return.

In addition, the projected $6.00 dividend generated in Year 10 in above scenarios resulted in a 6% yield on the original purchase price of the investment. This yield on cost will continue to grow as long as the dividend continues to increase.

Emphasizing the income component of total return may help an investors perspective about the whims of the market, the risk of plunging valuations, or prospects of a large distribution in several years. A focus on dividends may also reduce the infatuation with quarterly portfolio performance by directing attention toward the portfolio's potential ability to generate a growing income stream.

More on dividends and their relationship to total returns:

• Stock yields were greater than bond yields from 1926 until 1958. Afterwards, bond yields were higher, and this relationship continued until November 2008, when the yield on the S&P 500 surpassed the yield to maturity of the 10-year Treasury.
• The average dividend payout ratio was around 70% from around 1870 through the mid-1940s before moving closer to 50% the second half of the century, shrinking to near 30% in 2006.
• Dividend yields hit an all time low in 2000.
• Dividends accounted for more than 40% of the total returns from stocks from 1926 to 1990, but that contribution fell to 17% from 1991 to 2006 as rising valuations during the bull market skewed returns toward capital gains.