Today, investors can own a portfolio of solid dividend-paying stocks that provide income, but also have the potential for capital appreciation. To me, this is a compelling investment alternative to bonds for income generation, at this point, since long-term interest rates are at or near record lows. Additionally, we have seen dividend-paying stocks in the S&P 500 Index significantly outperform non-dividend paying stocks over the past year. In 2011, dividend-paying stocks in the S&P 500 Index increased 3.4%, on average, compared to non-dividend paying stocks which only returned 1.7%. However, there is a strategy to investing in dividend-paying companies that can “boost” results even more.
It’s easy to put together a portfolio of dividend-paying stocks; however, an important part of investing in these types of stocks is the growth of the dividend. This “boosting” strategy is investing in businesses that have grown their dividends more than 10% over the last five years. In fact, the companies in the S&P 500 that have grown their dividends more than 10% over the last five years had a 5.9% stock price increase, on average, for 2011. This represents more than 1.5 times the return of the average dividend-paying stock in the index for 2011, and 3 times more than the non-dividend paying stocks. The reason these corporations performed so well is because they were able to grow in the current economy. They are winners. They have grown their earnings through the recession and many are now earning all-time high profits. These corporations do not need the economy to improve – they are winning now. They are investing in their businesses and still have enough extra cash to increase the dividends paid to shareholders. This is the type of company in which I prefer to invest.
I spend a lot of time looking for businesses that have strong competitive advantages and will endure over a long period of time. I like to see managements that are innovative and know their industries inside-and-out. These leadership teams must be honest and ethical and deal with shareholders of the company in a forthright manner. I also want them to have low debt on the balance sheet, earn a high return on their capital, and generate more cash than they need so that they can use the money to increase value for their shareholders. In addition to paying out dividends, they are able to buy back stock, reinvest in the operation, and/or make acquisitions. Once I find these enterprises, I typically buy a significant amount of shares and hold onto them for several years allowing the business to grow. During this period, I meet with management regularly to ensure that my investment thesis is still intact.
Dividend-paying stocks do not insulate an investor from stock market volatility; however, a shareholder can certainly capture the dividend regardless of price fluctuations. So if you are looking for income, remember that it is possible to invest in a growing revenue stream through dividend-paying stocks while also having the potential for capital appreciation.
Fenimore Asset Management (Fenimore) is an independent investment advisory firm located in Cobleskill, NY and has been hand-selecting investments for almost four decades. Fenimore manages individual and institutional portfolios, and two mutual funds – FAM Funds – the FAM Value Fund and FAM Equity-Income Fund.