Dividends for the Long Run (Commentary by Chris Fleischmann)

by Chris Fleischmann  on Monday, Mar. 12, 2012 12:00 am  

Anyone who has suffered from motion sickness while riding in a boat will tell you it is a miserable experience. They may also tell you that focusing on one point on the horizon will reduce the nausea that comes from the rise and fall of the waves.

At 3, my niece was especially susceptible to sea sickness. As is the case with many 3-year-olds, she lacked the requisite attention span to keep her eyes focused on the horizon. Consequently, it was not uncommon to hear a small voice call for the captain, her grandpa, to cut the engines so she could "poook." Her condition required her to trade the enjoyment of skiing and cruising around the lake for the safety of terra firma.

In time, her ability to focus on the horizon and ignore the volatility of the waves improved, and by her 10th birthday, she was able to fully enjoy all the fun the lake has to offer.

Similarly, if investors can shift their focus to the steadiness of the dividends that companies pay to shareholders and ignore the rise and fall of stock prices, they may find it easier to stomach trading the safety of bonds for the enjoyment of a higher income in the form of dividends.

Five years ago, $1 million invested in the 10-year U.S. Treasury bond would have generated $47,100 per year. At current extremely low interest rates, $1 million invested in a 10-year U.S. Treasury would yield the grand sum of about $18,900 per year before tax. Also, while Uncle Sam has promised to return every penny of your $1 million at the end of 10 years, he does not guarantee its worth. Over a 10-year period, 3 percent annualized inflation will make $1 million feel like $660,000. Would you still consider a long-term U.S. Treasury obligation to be risk-free?

Investing in a dividend-paying stock, however, can provide you with a reasonably safe income stream that, through dividend increases, has the potential to offset the eroding effects that inflation has on your original investment. Dividend yields on stocks, for only the second time since 1958, exceed the "risk-free" 10-year U.S. Treasury bond yield of 1.89 percent (as of Dec. 31). The only other recent time investors showed this degree of aversion to stocks was during the height of the financial crisis during late 2008 and early 2009.

Despite the fact that a quarter of the S&P 500 index members do not pay a dividend, the index still sported an indicated dividend yield of 2.31 percent on Dec. 31. Not much to brag about, but it is higher than the 10-year U.S. Treasury, and it has the potential to grow.

While the following illustration lacks the academic rigor but possesses all the boredom of a peer-reviewed Journal of Finance study, our firm thinks it makes the point. We randomly selected five dividend-paying companies from five different industries that have had representation in our clients' portfolios at various times over the years. On the first day of business in 1980, if you had allocated your investment dollars equally among the shares of Dow Chemical (NYSE:DOW), ExxonMobil (NYSE:XOM), IBM (NYSE:IBM), J.C. Penney (NYSE:JCP) and Merck (NYSE:MRK), your current portfolio's annual dividend income would represent a 38.4 percent yield on your original investment. As a bonus, the value of your portfolio, excluding dividends, would be 13.34 times your original investment.

We believe investors who consider stocks for their ability to generate a growing stream of income, rather than being distracted by the daily ups and downs of their share prices, will be rewarded for their focus. Keep your eyes on the long-term horizon.

Chris Fleischmann is an analyst and portfolio manager with Foundation Resource Management of Little Rock, a fee-only registered investment adviser with approximately $2 billion under management. Email him at CFleischmann@FoundationResourceManagement.com.

 

 

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