Dividend stocks are making a comeback.
Because companies that pay and grow their dividends tend to be more well-heeled value stocks — as opposed to growth stocks — the group tends to be more defensive than the general market. Dividend stocks may lag in a stronger market, but are more likely to outperform in a down market.
While the Standard & Poor’s 500 index is off more than 2.8 percent so far this year, the S&P High Yield Dividend Aristocrats index and the Dow Jones U.S. Select Dividend index are both up roughly 3 percent. The broader WisdomTree Dividend index is down just 0.04 percent.
From 1972 through 2014, dividend-paying stocks in the S&P 500 provided an average annual total return of 9.3 percent, compared with non-dividend paying stocks that generated 2.6 percent returns, according to Ned Davis Research. Companies that grew their dividends performed even better.
“They generate better returns with less volatility,” says David Bahnsen, chief investment officer of the Bahnsen Group, part of Chicago-based private wealth management company HighTower Advisors.
Dividend aristocrats are strong companies. With the markets struggling this year amid economic growth concerns, dividend stocks could outperform the market as investors look for the safety of big dividend-paying companies, says Mike Binger, senior portfolio manager with Minnesota-based investment advisor Gradient Investments.
During a down market, Binger says, people are more likely to sell Netflix (ticker: NFLX) before they sell a tried-and-true stock like Procter & Gamble Co. (PG) — a stock that pays a strong 3.2 percent dividend and has increased its payout for 59 consecutive years.
Dividend growth tends to be correlated to companies that are stable and generate ample free cash flow, he says.
Companies that offer higher dividends tend to be more thoughtful on how to use that cash, as budget discipline is needed to support dividends, says Patrick Kaser, portfolio manager at Philadelphia-based asset manager Brandywine Global Investment Management.
Dividend stocks can also provide important income for people entering retirement, Binger says. People wary of stocks after getting burned in 2008 “can sleep easy at night” with all of their U.S.-based equity holdings in blue-chip dividend stocks because they are more stable with less risk and offer the comfort of big names and receiving income, he says.
Strong dividend stocks can also make weathering volatility more bearable, Binger says. Even though stock valuations are going up and down, the dividends will keep coming and growing.
Over time, Johnson & Johnson (JNJ), Lockheed Martin Corp. (LMT) and Philip Morris International (PM) have been notable dividend payers and growers, Binger says.
In addition to PG stock, Bahnsen, recommends Wal-Mart Stores (WMT), AT&T (T), General Electric Co. (GE), Intel Corp. (INTC) and McDonald’s Corp. (MCD) as good dividend stocks.
There are bargains to be found. However, just buying a basket of stocks with the highest dividend yield hasn’t been shown to outperform, Kaser says.
Sometimes, companies have higher yields because they are in distress, the market is calling into question the sustainability of their dividends, and the cheap stock price is warranted. Other times, companies, such as real estate investment trusts, are paying out most of their profits in dividends because that’s the way they are structured.
There are also companies that are paying dividends that they can’t afford, such as Citigroup (C) in 2008 when it cut its dividend by 41 percent, Bahnsen says.
Investors should seek undervalued gems that have good balance sheets, strong yields and free cash flow, Kaser says.
He likes Cisco Systems (CSCO), which as a technology company isn’t always thought of for higher yield. But the company has been a good performer throughout the financial downturn and is currently yielding more than 3 percent.
Department store chain Kohl’s Corp. (KSS), which is yielding around 4 percent is another standout, he says. It has room to grow its dividend, and the company isn’t as under threat from Amazon.com (AMZN) as other retailers because apparel is not one of the online behemoth’s strong suits, he says.
Binger points to dividend-paying stocks whose share prices have gotten hit and may offer a bargain, plus a future of what are likely strong dividends. Exxon Mobil Corp. (XOM), which has been hit by falling oil prices, remains a good dividend stock because of its size and diversification within the energy industry, he says.
Qualcomm (QCOM), is another company whose shares are down amid worries including over the softening growth of the smartphone market, but its cash flow generation is stable, as is its ability to pay its dividend, he says.
Beware of the strengthening dollar. A risk for dividend stocks is a strengthening U.S. dollar, as many of the larger dividend-paying names sell goods overseas and a stronger dollar diminishes profits earned in local currencies, Binger says.
And like with anything, there is the risk of overpaying, Kaser says.
Shoppers should look at the price-to-earnings ratio and not just the dividend in isolation. A 4 percent dividend payout isn’t going to mean much to someone who buys an overvalued equity and the stock price ends up dropping 20 percent, Kaser says.
Interest rates are another risk. In a rising interest rate environment, investors may move away from dividend-paying utilities, which are considered bond proxies, and into bonds themselves.
However, a lower-for-longer interest rate environment would bode well for dividend stocks, Kaser says.
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Why You Should Own Dividend Stocks originally appeared on usnews.com