Dividend strategies for 2012 and beyond

A dividend investing strategy is a smart way to generate income and total return, as history has shown. Dividend-paying stocks have outperformed non-dividend payers over time; since 1990, consistent dividend payers, as represented by the S&P 500 Dividend Aristocrats, earned an annualized 11.04 percent total return, while the broader S&P 500 index earned only 8.23 percent.1 In low-rate, low-growth environments, this outperformance is often even more pronounced. For the year ended December 31, 2011, dividend payers of the S&P 500 had an average total return of 1.4 percent versus 7.6 percent for non-dividend payers.

But dividend-paying stocks could come under pressure this year as a result of several factors. According to Standard & Poor’s, if the domestic economy continues to pick up steam, investors are likely to shift assets from defensive into more cyclical sectors in what is known as sector rotation. Defensive sectors, such as Telecom Services, Utilities and Consumer Staples, have offered the highest yields, while cyclical sectors, such as Consumer Durables and Technology, have offered lower yields.

Another source of potential pressure is the concern that taxes on dividend income may rise. Under current law, the federal tax rate on qualified dividends will increase from 15 percent to 20 percent on Jan. 1, 2013. What’s more, under the budget proposal submitted by the Obama administration, dividend income would be taxed at the much higher earned income rate for households making more than $250,000 annually ($200,000 for single filers). Such increases could reduce the appeal of dividend-paying stocks as investments for income-oriented investors. Even if Congress extends current rates and rejects the administration’s budget proposal, the uncertainty of dividend tax rates could put pressure on dividend-paying stocks.

Given this environment, dividend investors should view dividend-paying stocks as a multiyear play. Dividend payout ratios, currently near historic lows, will likely rise over time as today’s cash-rich companies see increasing pressure to share the wealth. Long-term demand for dividend-paying stocks should also be boosted by the wave of baby-boomers entering retirement over the next two decades, many of whom will be seeking income-paying alternatives to low-yielding bonds. 

Other strategies to consider:

Look for high-quality issues with an established history of dividend payment and annual increases. Such companies are represented by the S&P 500® Dividend Aristocrats index, which measures the performance of large-cap, blue-chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years. As noted above, this index has outperformed the broader S&P 500 Index since its inception in 1990. These long-term dividend payers have a proven track record and are more likely to continue paying dividends. Many are also sitting on record amounts of cash.

Diversify Sectors Defensive sectors such as Telecom Services, Utilities and Consumer Staples are likely to still offer the highest average yields. But if the US economy continues to improve, they may see erosion in prices. By diversifying, investors may be able to offset potential price losses with gains in sectors that are better positioned to benefit from an expanding economy.

Consider Euro Zone stocks, which may offer higher yields in the current environment. While the US economy has made strides in recent months, the Euro Zone remains mired in recession. A more defensive stance in Euro stocks is warranted, which favors dividend-paying sectors. Keep in mind, however, that higher yields, especially abnormally high yields, can be a warning flag that a company is not in good standing and has fallen out of favor with investors for any number of reasons.

Categories: Finance