A Buck in the Hand…

March 10th, 2011
by Portico Wealth Advisors

In a world where cash yields are non-existent and those for bonds are not much better, where equity multiples appear to once again be rapidly approaching “white hot” status, and where the scepter of significant inflation looms in the not so distant future, investors are left with few appealing options. Where can a risk-minded, inflation-conscious investor turn in this environment? Dividend-paying stocks.

At Portico, our portfolios were tilted towards dividend payers for the entirety of 2010. And even though the market has been on a bends-inducing ascent that has primarily rewarded “go-go” growth stocks over the past 6 months, we are more convinced than ever that those companies that dole out dividends are the right place to be for equity investors moving forward.

Three primary reasons that we are still sanguine on dividend payers are as follow:

  1. The Macro-Economic Environment
  2. Preferential Tax Treatment
  3. Better Returns, with Less Risk

Beginning with the macro-economic environment, it is clear that the economy has improved over the past 18 months, or at least its avatar, the stock market, has. However, if we look beyond the “projections,” what we see are systemic issues that have shown very few signs of improvement. Unemployment, housing gluts, Middle East turmoil, and fiscal crises at every level of government represent persistent and formidable headwinds in the face of long-term growth. Add to these issues the twin towers of potential interest rate hikes and wide-scale inflation and you have a scenario where fixed and capital assets alike could be steadily eroded.

Dividend-paying stocks may strike a unique balance in this environment, representing a desirable combination of current income as well as inflation-hedging growth. And given that dividend payers have lagged their growth-oriented brethren over the past year or so, their valuations appear more reasonable today.

In terms of tax treatment, dividends, at least those that are qualified (i.e. paid by a company based and/or operating in the US) are taxed at long-term capital gains tax rates. In other words, the highest rate at which an investor’s dividends will be taxed is 15% federally. Yes, dividend income can push other earned income into higher marginal brackets, effectively increasing the tax on dividends above 15%. However, there is no denying that 15% is one of the country’s lowest marginal tax rates. So the more income that one can have taxed at that level, the better.

Historically, investors have often viewed dividend-paying stocks as a lower risk, and hence lower return, proposition. However, a recent article appearing in Advisor Perspectives by Thomas Howard, PhD highlights what some academics have been touting for quite awhile now: dividend-paying stocks not only engender less risk, but they have generated significantly better returns over time as well.

Howard goes on to point out that over the past 27 years, companies that opted to “share the wealth” through the payment of dividends have produced returns that were nearly 4 times greater than those that opted to retain and reinvest their earnings. Moreover, firms that consistently raised their dividends during the same period boasted returns that were over 7 times those of non-dividend payers. Turning to risk, dividend payers were over 20% less risky during the period, as defined by standard deviation, while the consistent dividend growers were close to 35% less volatile.

Investors are living through a potentially rough time of low real returns. While dividend payers will continue to gyrate with the broader market, their dependable and growing stream of income may provide an increasingly rare combination of downside cushion and steady cash flow. Further, the additional surety of dividend payers has not historically come at the expense of returns. So the old axiom of the bird, or this case the buck, in the hand appears as though it will continue to pay dividends of its own for the foreseeable future.