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Dividends were like the cherry on an ice cream sundae last year — contributing nearly three percentage points of the market's 32.4% total return. After such sweet gains, however, investors may want to make dividends more of a main course in their portfolio.
Stocks are off to a rough start this year with the S&P 500 (.SPX) down roughly 4%. Analysts worry that a slowdown in emerging markets could hit profits for U.S. companies. The Federal Reserve is scaling back its stimulus, creating another headwind for the market. And stocks no longer look cheap with the S&P 500 trading at a trailing price/earnings ratio of 18.2, up from 17.5 a year ago.
This doesn't mean stocks are due to fall. Stock prices follow earnings growth and as long as corporate profits are rising, which they have been overall, stocks should have some support. Profits for S&P 500 companies are forecast to grow 10.3% this year, up from 4.5% growth in 2013, according to FactSet.
Yet after last year's rally, some fund managers think stock performance will be more muted from here. "Our conclusion is that this is a time of unusual risk ahead in stocks," David Wright, managing director of Sierra Investment Management, wrote in a recent report to clients.
If stocks do meander, the onus will shift to dividends to drive total returns. Dividends have contributed 34% of the S&P 500's total returns since 1926, according to S&P Dow Jones Indices. And they have played a much bigger role when stocks have slumped. During the 1970s and 2000s — eras of flat or declining stock prices — dividends were the only return investors received.
Another reason to focus on dividends: They can help fight inflation.
Companies that raise their dividends provide a rising stream of income every year. If a company is growing its dividend at the inflation rate or better, your investments are more likely to maintain their purchasing power. By contrast, bonds pay a fixed rate of interest that insures a "real" loss if inflation picks up.
Granted, rising rates pose a threat to some dividend-paying stocks. Utilities and slower-growth stocks with high yields tend to see their P/Es fall as interest rates rise, says Sarat Sethi, a portfolio manager with Douglas C. Lane & Associates in New York. Companies with lots of debt could also face pressure, as would businesses that use outside financing to cover their dividend payments.
High-yield stocks should be supplemented with growth companies too. "When inflation comes back you want growth stocks, because investors will reward growth," Sethi says.
Investors can mix and match funds, ETFs and stocks to tailor a strategy to their needs. A 45-year-old might want to emphasize stocks with lower dividends and greater potential for capital gains, says John Montag, chief investment officer of A. Montag & Associates in Atlanta. If you need more current income, you'd want stocks with higher yields and lower growth potential.
"For some people a 3% portfolio yield is fantastic," he says. "For others, 4% is fantastic. It depends on your needs and the risks you want to take."
In the dividend growth camp, one ETF to consider is the Vanguard Dividend Appreciation Index ETF (VIG). The fund tracks an index of large- and mid-cap U.S. companies that have raised their annual dividends for at least 10 years. It avoids utilities and is packed with quality stocks that have high profits, low debt and steady earnings, according to Morningstar ETF analyst Samuel Lee.
Some mutual funds hold a mix of dividend payers and growth stocks. One top-ranked fund, according to Morningstar: Parnassus Equity Income (PRBLX).
The fund screens stocks for financial strength and social responsibility, and keeps 75% of its money in dividend payers. Performance has been mediocre lately but the fund beat 98% of large-cap peers over the last decade while taking below-average risk, according to Morningstar.
Key risks: The ETF and fund could underperform in a market that rewards growth companies.
Individual stocks can also be a good way to generate dividend income, though they carry more risks than funds. The following are suggestions from financial advisers we interviewed. They should not be taken as recommendations but rather as starting points for further research.
For dividend growth, the adviser Sethi likes Apple (AAPL), consulting company Accenture (ACN) and restaurant chain Yum Brands (YUM). The companies have rising earnings and low payout ratios, leaving room for them to raise their dividends as profits climb, he says.
Key risks: Each company faces business and industry challenges that could pressure their stocks.
For higher income, investors could add utilities, telecoms, drug and consumer stocks.
Two utilities the adviser Montag likes are Northeast Utilities (NU) and Pacific Gas & Electric (PCG). The stocks yield 3.5% and 4.5%, respectively, and after a weak showing in 2013 both trade off their 52-week highs.
Verizon Communications (VZ) looks attractive for its 4.4% yield and dividend growth potential, says Sethi. The telecom giant has been growing its dividend at a 3.8% annual rate and reported a 9.2% jump in net income last year.
In the pharmaceutical space, Sethi suggests Novartis (NVS). The Swiss drug giant makes everything from vaccines to cancer medicines and should grow earnings at a 6% rate over the next four years, according to Leerink Swan analyst Seamus Fernandez. Novartis pays out 63% of its profits in a dividend and could hike its dividend as earnings expand.
Kraft Foods (KRFT) also offers potential for dividend growth, Sethi says. Yielding 3.8%, the stock has a 47% payout ratio, leaving room for higher payouts as Kraft boosts earnings.
Key risks: Utilities and telecom firms are among the most interest-rate-sensitive stocks, meaning their prices tend to fall in a rising rate climate. Novartis could face setbacks in its drug pipeline. Kraft's P/E ratio is relatively high compared to its growth rate.
Real estate investment trusts (REITS) gained just 2.4% last year, according to the MSCI US REIT Index. Higher rates were the headwind. Yet compared to bonds, REITs still look attractive, yielding 3.8%, according to the Dow Jones U.S. Select REIT Index, well above the 2.8% rate on a 10-year Treasury note. REITs also offer some inflation protection since property prices tend to rise with inflation.
Two firms Sethi likes are AvalonBay Communities (AVB) and Ventas (VTR).
AvalonBay owns around 70,000 apartment units in coastal urban areas — regions with strong demand for rentals. The dividend has jumped 53% over the past decade, according to the firm.
Ventas owns 1,476 senior-living properties, including skilled-nursing facilities and senior housing communities. Dividends per share have grown at a 9% compound annual rate since 2000 and the firm's 65% dividend payout ratio, while on the higher side, still leaves room for growth.
Key risks: Rising interest rates could pressure the stocks. REITs typically distribute ordinary income, making the stocks best held in a tax-exempt account.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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