Friday, April 27, 2012

Yet Another Reminder of Why We Should Own Dividend Stocks Instead of Bonds

From time to time we've discussed the outlook for fixed income investing during the next ten to twenty years. It's not promising.

In all probability, a better investment than bonds will be the shares of well capitalized solid performing blue chip companies with a record of growing earnings and increasing cash dividend payments.

Dividend Stocks Become the Heroes is a short but good article extolling the current virtues of investing in dividend stocks and how these stocks have outperformed the market in 2011.

Here's the short term argument in brief:

"In the first half of the 20th century, companies had to pay richer dividends on stocks than on their bonds in order to compensate investors for the higher risk of holding equity. Over time, high-dividend stocks have gotten less attention from investors than growth stocks, except for scurries during periods of economic stress.

High-dividend companies have typically seen their price-to-earnings ratios trade 20% or more lower than non-dividend-paying shares over the past three decades, according to AllianceBernstein. This year, though, valuations on dividend-hefty shares caught up with their no-dividend peers for the first time since the late 1970s.

McDonald's is a darling dividend stock of many investors. The fast-food chain's stock-price surge of 27% in the past year leads every other Dow Jones Industrial Average component.

McDonald's has a dividend yield of about 3%, outpacing the 2.625% coupon bond issued by the company in September, due in 2022. McDonald's has boosted its dividend by an average of 27% annually in the past five years, according to Haverford Trust Co.

"You have the best of both worlds: a company that has seen the stock price go up, and they've increased their dividend," says Hank Smith, chief investment officer at Haverford. The firm manages more than $6 billion in assets."

But that's only one stock. And one brief period of time. What about stocks generally and a longer term horizon for investing?

In other words, today's timeliness argument for investing in dividend stocks doesn't necessarily mean that it will be timely tomorrow. That's why the article's following comment is most revealing:

""We think our message about the importance of dividends is a timeless one," says Joe McLaughlin, Haverford's chairman and chief executive. "But obviously, it's also very timely right now."

I agree that stocks paying high cash dividends relative to the price of their shares has been a good approach recently.

I also agree that this approach is going to be a good one for the long term, too.

That's because stocks that pay dividends have the likelihood of paying even higher dividends in the future as earnings grow. And as their earnings grow, the shares of these companies also have the potential to appreciate in price. Thus, both the prospects for growing dividends and appreciating share prices give blue chip stocks the decided edge over investing in bonds or fixed income securities.

Especially when we're investing in a low inflation environment like today, or perhaps even an accelerating inflationary environment at some point down the road.

So why invest in fixed income securities or bonds for the longer term? I can think of no good reason, assuming deflation doesn't take hold. And I don't believe it will.

So other than on those rare occasions, such as the 1980s, when inflation and interest rates have peaked and a period of disinflation is about to occur, stocks will outperform bonds. At least that's my strongly held view.

In the above referenced article, McDonald's is offered as an example of the benefits accruing from owning dividend increasing blue chip stocks. Other examples that come to mind are such blue chip companies as Intel, Microsoft, Pfizer, Merck, Johnson & Johnson, GE, Pepsi, Coke, Nucor, U.S.Bancorp and Wal-Mart. There are many others as well.

In the case of McDonald's, the interest paid to bondholders is lower than the dividends paid on the stock. That hasn't happened routinely since the 1950s for companies generally. Thus, today looks good for investing in the shares of dividend increasing companies, whose dividends are most likely to be accompanied by solid earnings growth over the longer term.

At least it looks that way to me.

Let's take McDonald's. McDonald's is able to pay both its dividends and its interest on debt from its earnings. Thus, the source of the funds paid is the same.

Historically debt is deemed to be less risky than shares of stock, since dividends don't have to be declared by the company, but interest costs, barring bankruptcy, are certain.

To me that doesn't make McDonald's debt substantially less risky than its stock. If we're worried about the company's ability to either service its debt or continue to declare its dividends, we shouldn't own either the stock or the debt of the company. We should stay away from both.

Of course, there's risk involved with owning shares of stock. There is also risk with owning debt. There's always risk involved with investing. And with not investing as well.

In fact, there's risk associated with eating too much or little, exercising too much or little, driving the car and all other life experiences. That's life. Risk is nothing more than a four letter word. Risk is.

We simply have to learn how to live with and manage that omnipresent risk as best we can.

For investors, there's the clear inflation risk involved with not investing, too. Cash tends to become less valuable over time as inflation makes that 'old' money worth less each year it's owned.

Today we can buy good stocks that pay 3%-4% in dividend yields. For a comparison, ten year maturity government bonds pay less than 2%. Without even considering the income tax preference for dividends over interest income, dividends are the obvious winner.

That's because, unlike bonds, dividends and the stocks' prices are both likely to increase over time.

The only practicable way bonds will be priced higher is if interest rates continue to decline. But that's not in the cards as rates are already almost zero. Thus, the odds of further interest rate reductions are slim indeed.

Besides, for that to occur would mean that we will have an even sicker economy than today's.

So what to do? Buy a few 3.5% dividend yielders today, plan to hold them for the next twenty years and watch the yield on cost (what we paid for the stock initially) grow to 14% or higher. Then watch the share prices double or triple as well.

Otherwise, be content to stay out of the investing scenario entirely and plan to be satisfied with accepting 2% interest rates in a longer term 3% or higher inflationary environment. That's accepting a negative real return, and I don't recommend it.

Thanks. Bob.

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