Given the historically low rates associated with fixed income investments over the past few years, financial advisors and individual investors have been increasingly looking to dividend paying equities to provide for income. However, dividends can also contribute significantly to the total return potential (i.e. includes income from dividends and interest as well as the appreciation or depreciation in the price of the security over a given period of time) of an equity investment. To this end, according to Fidelity, from 1930 to September of 2010, dividends represented 44% of the S&P 500 Index’s 9.3% average annual total return. In my opinion, this data provides credence to my long term belief that dividends are a critical component of total returns and should be a critical ingredient towards selection criteria for those investment strategies looking for some combination of growth and income. With this said the question then becomes in which market environments should one focus on dividend oriented strategies and how can one pick the best, or most appropriate, dividend strategies for each investment portfolio.
Generally, dividend or value oriented investment strategies (as value strategies are typically associated with higher dividend payout and lower price/earnings ratios) perform well within a stock market that trades up modestly, sideways or experiences periods of increased volatility or negative performance. However, these investment strategies can also perform well during bull markets based upon the relative company fundamentals and associated sector. These strategies can be accessed through investments in common stocks, open end mutual funds, closed end funds and exchange-traded funds (ETFs).
- Common Stocks – some attributes that we generally review when selecting dividend oriented common stocks include:
- Current dividend yield
- 1, 3 and 5 year dividend growth rate history
- Free cash flow balance (12 month)
- 1, 3 and 5 year total return history relative to peers
- Mean analyst recommendation (current and trending)
- Average volume
- Open End Mutual Funds – some attributes that we generally review when selecting dividend/value oriented open end mutual funds include:
- Sub-Asset class (generally favor value and large capitalizations or dividend specific strategies)
- Current dividend yield
- 1, 3 and 5 year dividend growth rate history
- 1, 3 and 5 year total return history relative to peers
- Expense ratio
- Total assets & average volume
- Closed End Funds – some attributes that we generally review when selecting dividend/value oriented closed end funds (CEFs) include:
- CEF Connect category (generally review the equity categories of Covered Call, Dividend Equity, Equity Tax-Advantaged, Growth & Income, Real Estate(Global), Real Estate (US), MLP, Global Equity Dividend and Global Growth & Income)
- Current dividend yield
- 1, 3 and 5 year dividend growth rate history
- Current Earnings/Current Distribution Ratio (preferably positive)
- Undistributed net investment income (UNII) balance (preferably positive)
- 1, 3 and 5 year total return history relative to peers
- Expense ratio
- Amount and type of leverage (if any)
- Total assets & average volume
- Exchange-traded Funds (ETFs) – some attributes that we generally review when selecting dividend/value oriented exchange-traded funds (ETFs) include:
- Sub-Asset class (generally favor value and large capitalizations or dividend specific strategies)
- Current dividend yield
- 1, 3 and 5 year dividend growth rate history (though many ETFs do not have 5 years of historical data as of yet)
- 1, 3 and 5 year total return history relative to peers (though many ETFs do not have 5 years of historical data as of yet)
- Expense ratio
- Tracking error (the lower the better)
- Total assets & average volume
Regardless of the current status of the economic climate or stock market environment, investment strategies that focus on companies with a long term history of sustainable and growing dividends, with attractive cash laden balance sheets, which are well positioned within their industries/sectors, should be able to find a home in most investment portfolios.