Dividend Reinvestment Can Be a Stable Source of Long-Term Returns

Many dividend companies are resilient and poised for growth due to their ample cash flow.
Many dividend companies are resilient and poised for growth due to their ample cash flow.

Investors have been pouring into stocks that produce dividend payments. Reliable performers reward shareholders with quarterly dividend checks year after year. Popular stocks include phone giant AT&T, which pays a dividend yield of 4.6%, and Duke Energy, a power company that yields 4.8%. 

For many investors, the rush into dividend payers represents a change from past patterns. For decades, income-oriented investors focused on bonds. That made sense because as recently as 2000, 10-year Treasury bonds yielded 6.0%, while the stocks of the S&P 500 yielded less than 2%. But since the financial crisis in 2008, the Federal Reserve has been holding down interest rates. Now Treasuries yield only 1.65%, much less than what many stocks pay. As a result, investors have been looking to dividend stocks.

A sound strategy

Focusing on companies that pay dividends can be a sound strategy. Many dividend companies are mature businesses with a rich cash flow. Such shares can be resilient in downturns and produce solid long-term returns. But investors should be careful not to simply buy stocks with the highest dividends. In the arithmetic of the markets, dividend yields rise when stocks fall. If a stock costs $20 and sends out $1 in dividend checks annually, the yield is 5%. Now if the company runs into trouble and the shares fall to $10, the yield will jump to 10%. While the big yield may be tempting, investors should be wary because shaky companies can cut dividends or stop them altogether.

For better results, look for stocks that pay dividends of 2% to 5% and increase them every year. A solid choice is ketchup maker H. J. Heinz, which yields 3.7%. Heinz has a long record of raising its dividend. While the company paid $1.68 per share in 2010, it increased the payout to $1.80 in 2011 and $1.92 in 2012.

Keep in mind that stocks like Heinz are very different from bonds. Bonds make fixed payouts that never increase. Bonds may be safer, but by buying stocks that increase their payouts like clockwork, you can achieve a steady flow of income that will grow for years.

S&P Dividend Aristocrats

To find potential investments, consider the S&P Dividend Aristocrats, a group of stocks that is listed at S&P.com. To be included on the list, a stock must have increased its dividend every year for the past 25 years. Only 52 companies qualify. The group includes such reliable blue chips as drug chain Walgreen, oil giant Exxon Mobil, and bleach maker Clorox. Companies on the list tend to be extremely committed to raising their dividends. Managements will move heaven and earth before they cut payouts to shareholders. 

Make no mistake: The companies on the list do not come with ironclad guarantees. During the financial crisis, a number of them cut their dividends and were eliminated from the list. One of the biggest disappointments came when General Electric cut its dividend for the first time since the Great Depression. Still, the list provides a good starting point for investors seeking reliable performers.

Utility-based stocks

The list has several utilities, including Consolidated Edison, a New York power company that yields 4%. Utility payouts are typically safe because state governments regulate such businesses, and the demand for power remains steady. But investors should be careful about weighting their portfolio with utility stocks. Seeking security, investors have poured into utilities, pushing up prices well above normal levels. The high prices may not be justified because many utilities only increase earnings slowly.

To hold dividend stocks, consider buying a mutual fund. A top choice is T. Rowe Price Dividend Growth. During the past five years, the fund returned 2.2% annually, outdoing the S&P 500 by about one percentage point. Portfolio manager Tom Huber is wary of utilities. Instead of high-yielding stocks, he is focusing on companies with smaller dividends that are growing steadily. “You can find some attractive situations where the stocks are yielding 2%, and the dividends are growing at 9% annual rates,” he says.

Huber likes United Technologies, the maker of Pratt and Whitney aircraft engines and Otis elevators. The stock yields 2.7%, and the dividend has been increasing steadily. The company has been boosting sales by expanding into emerging markets. Huber also likes Kohl's, the department store chain. The stock yields 2.4%. He says that the management is committed to raising the dividend, and the company has plenty of cash to support payments.

Another solid fund is Rochdale Dividend & Income, which returned 4.2% annually during the past five years. To find growing dividends, portfolio manager David Abella has been buying healthcare REITs (real estate investment trusts). Those own facilities that house hospitals, medical offices, or nursing homes. The Rochdale fund holds Ventas, a REIT that yields 4.0%. Ventas owns properties that house nursing homes and assisted living facilities. Demand for such properties is growing relentlessly as the population ages, Abella says. But there has been relatively little construction lately because the financial crisis discouraged lenders from taking risks. That has helped to keep properties filled. “Healthcare REITs should do well even if the economy remains sluggish,” Abela says.

He has been wary about pharmaceutical stocks because patents are expiring on many drugs. That should hurt sales and earnings. But Abela favors Bristol-Myers Squibb, which yields 4.0%. The company is developing some promising drugs that should provide enough cash to cover the dividend.

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