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Dividend Stocks Become the Heroes

December 19, 2011 — The Wall Street Journal — By Jonathan Cheng   Bookmark and Share

A digital billboard greets commuters backed up in morning traffic along a bend in the Schuylkill Expressway snaking toward Philadelphia: "Earned Any Dividends Lately?"

Urging investors toward dividend-paying shares has been an easy sell. This year, the 100 stocks in the Standard & Poor's 500-stock index with the highest dividend yields are up an average of 3.7% before dividend payouts, according to Birinyi Associates. The 100 lowest-yielding stocks are down an average of 10%.

Dividend yield is calculated by dividing a company's annual per-share dividend by share price. In the third quarter, share-price returns on high-dividend payers exceeded those of lower-paying companies by 17 percentage points, AllianceBernstein calculates.

Investors hungry for stock-price gains have been barreling into dividend-paying shares, long regarded as "widow-and-orphan stocks" because of their steady but stodgy performance. Some analysts say such stocks are the most "crowded" trade around these days. Investors have been dazzled by dividend yields of more than 4% on many utilities, household-goods manufacturers and telecommunications companies. That is twice as much as recent paltry yields on 10-year Treasurys.

Dividend-stock fans say the unusually strong performance is likely to last as long as volatility driven by Europe's debt crisis and the global economic fits and starts continues to grip financial markets. Stocks that pay steady dividends tend to fall less than others when times are tough.

And there could be a new boost if companies with record-high mountains of cash on their balance sheet give in to prodding from shareholders to spread it around by increasing dividend payments. Overall, companies are paying out a smaller chunk of profits in the form of dividends than they typically have in the past.

"Investors are demanding the money back in one form or another," says Jennifer Ellison, principal and portfolio manager at Bingham, Osborn & Scarborough in San Francisco, which manages $2.2 billion in investments. Buying stocks with healthy dividends is "not the holy grail that's going to solve all your problems, but it's one more way to mute that volatility," she says.

Skeptics contend that dividend-rich stocks aren't as safe as they look.

The recent run-up is unsustainable, these doubters say, especially if economic conditions improve, which could cause investors to switch to higher-growth companies that tend to pay lower or no dividends.

In contrast to classic dividend-stock investors who care more about quarterly dividend payments than stock price, many recent converts bought the shares for income and the possibility of price gains. If growth stocks spring back to life, the same momentum that pushed dividend-rich shares higher could reverse with just as much force.

"A crowded trade is always risky," says Vadim Zlotnikov, chief market strategist at AllianceBernstein. Last week, he warned clients in a note that, while dividend stocks might keep outperforming the overall stock market, any signs of an economic upswing could quickly end the winning streak.

Mr. Zlotnikov says he was shocked by the angry response from dividend-stock lovers. "You have a lot of fund managers who are happy because they've seen a lot of new clients," he says. "Anyone who is even neutral will be viewed as being against a fairly clear, good investment theme."

In the first half of the 20th century, companies had to pay richer dividends on stocks than on their bonds in order to compensate investors for the higher risk of holding equity. Over time, high-dividend stocks have gotten less attention from investors than growth stocks, except for scurries during periods of economic stress.

High-dividend companies have typically seen their price-to-earnings ratios trade 20% or more lower than non-dividend-paying shares over the past three decades, according to AllianceBernstein. This year, though, valuations on dividend-hefty shares caught up with their no-dividend peers for the first time since the late 1970s.

McDonald's is a darling dividend stock of many investors. The fast-food chain's stock-price surge of 27% in the past year leads every other Dow Jones Industrial Average component.

McDonald's has a dividend yield of about 3%, outpacing the 2.625% coupon bond issued by the company in September, due in 2022. McDonald's has boosted its dividend by an average of 27% annually in the past five years, according to Haverford Trust Co.

"You have the best of both worlds: a company that has seen the stock price go up, and they've increased their dividend," says Hank Smith, chief investment officer at Haverford. The firm manages more than $6 billion in assets.

Ms. Ellison of Bingham, Osborn & Scarborough agrees with concerns that dividend stocks are "a defensive, quality play, and if we have big, big returns on stocks next year, no one will care." Still, if events in Europe and Washington keep hovering over the financial markets for years to come, as some investors expect, the recent surge might last, she says.

Such stocks could get an even longer-lasting lift as more baby boomers reach retirement age—and reduce their risk appetite. The first baby boomers turned 65 years old this year.

Haverford isn't changing direction in its portfolios of dividend-paying blue-chip stocks like McDonald's and Johnson & Johnson. The firm spends a few thousand dollars a month on the "Earned Any Dividends Lately?" billboard.

"We think our message about the importance of dividends is a timeless one," says Joe McLaughlin, Haverford's chairman and chief executive. "But obviously, it's also very timely right now."

Haverford is cooking up three new billboard slogans for 2012.