Among portfolio allocations to equities, a classic contrast has pitted dividend-paying value stocks against nonpayer growth stocks. But for advisors, a focus instead on dividend growth can offer rich rewards.

After all, for planners selecting dividend-paying stocks and funds for their clients, searching for the very highest yield can be a dangerous game. "Chasing yield in any asset class and in any environment is very risky," says Jeremy Paul, managing partner at RLP Wealth Advisors in New York.

In fact, Josh Peters, editor of Morningstar's monthly newsletter Dividend Investor, classifies the rich cash payments available from some equities as "sucker yields" because they are unlikely to be sustained. Even if their dividends are not cut, stocks with extremely high yields are viewed by the market as bond surrogates and tend to sell off sharply when interest rates rise - as, indeed, many did in June.

"I want the market to meet me in the middle, where I'm going to get both a good yield and a good growth rate for the dividend to drive my total return," says Peters, who defines a "good yield" in the current investment environment as 3% to 6%.

 

TOTAL RETURN

Historically, dividends have been a major contributor to total return. From December 1926 to December 2012, dividend income constituted 34% of the monthly total return of the S&P 500, according to a study by S&P Dow Jones Indices.

Jennifer Cole, an advisor in Sandia Park, N.M., cautions not to ignore other parts of the picture - like price stability, earnings growth and a good return on capital. "I'm really a total return person," she says.

But dividend growth is where she starts when evaluating an equity fund for her clients. "It has become, for me, a measure of quality," she says. Cole likes some WisdomTree ETFs, but usually picks those featuring earnings growth rather than dividend yield. "The earnings funds have almost as good a dividend situation, and they've got better growth," she observes.

Kevin Brosious, president of Wealth Management, an RIA firm in Allentown, Pa., does use some funds that focus on dividends. For the most part, he sticks with the Vanguard Dividend Appreciation ETF (VIG). "That's really a value play," Brosious says. He also uses the Vanguard High Dividend Yield ETF (VYM). That fund is based on an index that includes common stocks with above-market yields; recently, the top three holdings were ExxonMobil (XOM), Microsoft (MSFT) and GE (GE).

Brosious says he's comfortable putting clients in a fund holding such blue chips with growing dividends. He has taken a look at some other dividend-oriented portfolios and found them wanting. "After peeling the onion back, I didn't really like some of the companies they were investing in," he says.

 

STOCKS VS. FUNDS

Most advisors shun individual equities in favor of funds. "It depends upon the client but, as a general rule, we like to take individual company risk out of an investment," Paul says.

He has three go-to dividend-oriented funds: Sun America Focus Dividend Strategy (FDSAX), Federated Strategic Value Dividend (SVAAX), and JP Morgan Equity Income (OIEIX).

By contrast, Brosious is less inclined to dump individual stocks in favor of funds. If a client arrives with equity positions that have built-in capital gains, he says, he's more likely to advise holding on to them, especially if they are value stocks. "My first concern, always, is portfolio diversification," he adds.

For advisors who use common stocks or have clients with existing equity positions, evaluating a dividend payer is crucial. One standard metric is the payout ratio, the percentage of earnings paid out as dividends. Right now, U.S. common stocks pay dividends amounting to 36% of earnings, according to S&P Dow Jones Indices. The historical average payout ratio is 52%.

The payout ratio is an important figure. "It's a number that you build a lot of your analysis around," Peters says. But it can vary by industry. Peters notes that some oil refiners have low payout ratios in boom times, but when these cyclical businesses turn down, the companies lose money, making the ratio meaningless.

In contrast, some service businesses pay out a large portion of earnings in the form of dividends because capital expenditures are extremely low. "You have to know the business," he adds.

 

EYE ON INCREASES

Once an advisor is comfortable with a company's business, review its record of increasing dividends. Many stocks have decades-long histories of annual dividend increases. For a buy-and-hold investor, a portfolio including such stocks enhances the inflation protection that comes from holding equities.

Consider Colgate-Palmolive (CL). The household products maker has paid an uninterrupted dividend since 1895 and has increased its dividend annually for 50 years. But an investor who looks at Colgate's yield at any particular moment might think the stock uninviting. A decade ago, the average price of the stock was $27.40 (adjusted for a subsequent split) and the yield was a modest 1.6%. Colgate's recent yield, 2.4%, still does not seem like a high number. But for the investor who bought a decade ago, the current dividend actually represents a 5% yield on the cost of the stock. The company's dividend has increased at a 12.5% annualized clip over the past decade.

Some of the fastest dividend growth in the coming decade may be in an unlikely sector: information technology. "Technology issues have more cash than anyone else," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Although some older techs, including IBM (IBM) and Automatic Data Processing (ADP), had long paid dividends, Silverblatt says the sector's attractiveness to dividend hunters "started in January 2003 with a small company called Microsoft." Now, 44 of the 70 companies in the S&P 500 tech sector pay dividends. Their payments make up 15.6% of the S&P 500's current dividend - the largest contribution of any of the 10 sectors.

Currently, 82% of the stocks in the S&P 500 pay dividends, a level last seen in September 1999. The best percentage increases often occur in the first few years after a company initiates a dividend. "Even if you are foregoing current income, there's value to be added by companies that are new in paying dividends and [are] expected to grow that dividend over time," Paul says.

An example is biotech giant Amgen (AMGN). The company initiated a dividend in the second half of 2011 and paid 56 cents that year. Amgen has since raised its dividend twice, to a current indicated rate of $1.88. What's more, company officials are on record promising continued meaningful increases.

Of course, companies can manipulate early dividend increases. "Traditionally, a company initiates a dividend and usually they start the dividend at a slightly lower yield than the competitors," says Silverblatt, who add that the intent is to impress investors with the subsequent increase.

Peters is also a bit contemptuous of this ploy, asking, "Did earnings grow that fast, or are they just catching up with the dividend they should have been paying all along?"

  

Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor's weekly investment advisory newsletter, The Outlook.


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