Here's a clear case for owning dividend stocks instead of bonds

Your income can rise, and so can share prices over the long haul.

  • By Philip Van Doorn,
  • MarketWatch
  • Investing for Income
  • Investing in Bonds
  • Investing in Stocks
  • Bonds
  • Dividend-Paying Stocks
  • Investing for Income
  • Investing in Bonds
  • Investing in Stocks
  • Bonds
  • Dividend-Paying Stocks
  • Investing for Income
  • Investing in Bonds
  • Investing in Stocks
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  • Dividend-Paying Stocks
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Overvalued stocks and rising interest rates suggest bonds might now be a better investment.

But there’s a strong argument that shares of well-established companies with attractive dividend yields are much better long-term investments than bonds are.

Money managers use all sorts of complicated analyses and charts to explain why you should invest in, or avoid, a particular company or class of securities. Hank Smith, co-chief investment officer of Haverford Trust, has laid out a clear case for dividend stocks over bonds. (Haverford is based in Radnor, Pa., and has about $8 billion in assets under management.)

In an interview Sept. 18, Smith compared shares of PepsiCo (PEP) to 10-year U.S. Treasury notes. Pepsi’s stock had a dividend yield of 3.25% as of the close on Sept. 18, while 10-year U.S. Treasury paper yielded 3.05%.

If you go with the Treasury notes, “you know every year you will get 3.05%, and at the end of 10 years you are going to get your money back,” Smith said. “With Pepsi — no guarantees, but you can be reasonably assured you will get increases each year in that income stream.”

And that’s only considering the income from the two investments.

“After a handful of years you are going to be well ahead because of dividend increases, and it is reasonable to expect that at the end of 10 years, you will have more principal from your original investment in Pepsi than you will from your 10-year Treasury that finally matures.”

Pepsi has raised its dividend every year for at least 25 years, qualifying it for inclusion in the S&P 500 Dividend Aristocrats Index.

Of course, “there’s no free lunch” for investors, Smith said, because if you hold dividend stocks, you will have to put up with price volatility.

“But if you are investing in Pepsi for the current yield of 3.3%, with the expectation of income growth, you should not be as concerned with near-term volatility,” he said. “If Pepsi goes down 15% in value from today’s value, your income is not going to change.”

In fact, if the shares drop 15% from where you initially buy them, it might be time to increase your holdings, in part because the newly purchased shares will have higher yields.

Long-term stock charts typically show total returns with dividends reinvested. But for Pepsi, if we look only at price changes (assuming we are taking the dividend income), the long-term story is still a good one:

Some of those numbers may not seem particularly impressive, but remember they do not include dividends. Pepsi’s clear commitment to increasing dividends provides comfort on the income side and also supports the share price during down markets and over the long term. A comparison to a pure growth stock investing strategy is meaningless.

The importance of raising dividends

Smith explained that his “playground” for stock selection is large-cap companies with strong financials that pay dividends, “with more emphasis on the growth of dividends than higher yield.” But he added that for clients seeking income, the firm has a dividend income strategy with a portfolio yield of about 3%.

Two other companies he mentioned that fit the bill are Johnson & Johnson (JNJ) which has a dividend yield of 2.56%, and McDonald’s (MCD) which also yields 2.56%.

In the technology space, many of the most familiar stocks — including Facebook (FB), Amazon.com (AMZN), Netflix (NFLX), and Google holding company Alphabet (GOOG) (GOOGL) -- don’t feature any dividends at all.

But Haverford does hold these very large “old tech” companies for clients: Apple (AAPL) with a dividend yield of 1.34%, Microsoft (MSFT) with a yield of 1.48%, and Cisco Systems (CSCO) with shares yielding 2.78%.

Smith said that shares of companies that consistently raise dividends “are better performers over time than non-dividend-paying stocks.”

“The increase of a dividend is the most tangible statement management and its board of directors can make about their confidence in the current and future fundamentals of the company,” he said.

One reason is that companies raise dividends carefully because if they are forced to cut the payout, it typically wreaks havoc with the stock price.

Dividend Aristocrats

Looking at the S&P 500 Dividend Aristocrats, the only qualification for inclusion in this group of 53 S&P 500 (.SPX) stocks is that a company has raised its dividend consecutively for 25 years. This means yields aren’t necessarily high. Twenty-four of the S&P 500 Dividend Aristocrats have yields of 3% or higher, while 20 have yields below 2%, eight have yields below 1.50%, and four have yields below 1%.

But it turns out that merely raising dividends consistently has been correlated with significant outperformance over very long periods, when dividends are reinvested:

The Dividend Aristocrats have trailed the full S&P 500 for the one-, three- and five-year periods. However, for 10 and 15 years, their outperformance has been enormous.

One way to play the Aristocrats as a group for growth is the ProShares S&P 500 Dividend Aristocrats (NOBL).

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