Sweetening the dividend deal

(Money Magazine) -- You know that you're supposed to invest with your head and not your heart. But the truth is, a thriving stock market requires a lot of faith - in the economy, in corporate America, and in the promise that your investments will make you money in the long run.

Recently, faith in the economy has rebounded a bit, which explains why risk taking has re-emerged. But short spurts of enthusiasm won't erase the distrust of equities that's developed after two crushing bear markets caused by the misallocation of hundreds of billions of dollars, first into Internet stocks and then into housing.

"Corporate America has proven twice that it can't handle capital well," says Gordon Fowler, chief investment officer at Glenmede Trust, a wealth-management firm. "Because of that, investors will become more conservative." In fact, since the start of last year, about a quarter of a trillion dollars has left stock funds.

This penchant to play it safe could hinder equity returns for decades, just as it did after the Great Depression. The coming era is also likely to echo another post-Depression development: the growing emphasis on dividends - and not just in traditional income-producing areas of the market like financials, where payouts have recently taken a beating.

"Dividends will go up because investors will demand it from companies that have the cash," Fowler says. "I'll demand it." So will the mutual fund managers who run your 401(k) investments. And so will you. After all, which do you believe in now: the ability of corporate execs to reinvest profits at an acceptably high rate of return, or a quarterly cash payment?

Firms are getting the message. While a record number slashed payouts recently, more have increased or initiated dividends this year than have cut them - and that's even if you include financial companies. Strip out the banks, and there have been 75 dividend hikes among companies in Standard & Poor's 500 index, vs. only 29 cuts. Shaken investors will want "the bird in the hand - stable and secure income as opposed to uncertain capital gains," Pimco managing director Bill Gross noted in a recent commentary.

To appreciate why dividends will grow in importance, some market history is in order. You know that a stock's total return is made up of two parts: the dividends it pays out plus or minus any change in its share price. But the role of dividends has changed dramatically over time depending on how the other part of the equation has done.

Between 1980 and 2000, for example, stock prices soared because of two big tailwinds: strong earnings and the growing confidence investors had in the reliability of profits, reflected in rising price/earnings ratios, says Vitaliy Katsenelson, a money manager and author of Active Value Investing. As the S&P's P/E tripled to 25.7, P/E expansion alone accounted for more than a third of the market's returns, making dividends look insignificant.

Conversely, when faith in corporate America is tested, P/Es can stagnate or fall. Between June 1998 and June 2008, earnings grew a respectable 5% a year, but investor faith cratered. The result: The market's P/E, based on trailing 12-month earnings, sank from 25 to 18, and stock prices rose just 1.2% a year. Most of the money you made during this stretch actually came from dividends.

Where will valuations go from here? Based on 10-year averaged earnings - a long-term way of looking at profits that smooths out anomalies - the market's P/E stands at 16, which is about the historical average for the past 120 years. So don't count on P/E expansion to drive prices up as it did in the '80s and '90s, says Rob Arnott, chairman of Research Affiliates. "That isn't there anymore," he says.

If so, a strategy that stresses dividends and total returns over capital appreciation should stage a comeback. In the 1940s and '50s, investors grew so wary of stocks' risks that they focused almost exclusively on dividends. Their concerns, coupled with high payouts, pushed the dividend yield on the S&P 500 index much higher than that of 10-year Treasury bonds for two decades. In other words, there was so little confidence in stocks that investors demanded big upfront assurances from equities.

No one is saying that this will happen now. But neither are we likely to go back to a period when dividends are an afterthought.

This isn't the first time that a resurgence in dividends has been predicted. After the 2000-02 bear market - and following a tax cut in 2003 that slashed the top rate on qualified dividends to 15% - there was great expectation that companies would reverse the quarter-century trend of lower payouts. But the number of dividend payers in the S&P rose only modestly, from 351 in 2001 to 390 in 2007. Part of the reason: That bear was followed by the second-longest uninterrupted bull run in history. Even so, some parts of the market did change.

Take technology. In the 1990s only a handful of tech stocks paid dividends, because industry executives were certain that they could generate better returns by reinvesting their profits into their businesses rather than kicking money back to shareholders. That was at a time, you'll recall, when tech earnings were routinely growing by double digits annually.

After the crash wiped out 75% of the sector's value, though, many of those firms had a change of heart. Since 2003, there have been more than 100 dividend increases and initiations among tech firms, vs. four cuts. That helps explain how these companies restored investor confidence soon after the Internet bubble burst.

Expect firms in other industries to follow tech's lead. In April the luxury brand Coach announced its first dividend payments ever. "There was no better time than during a period of great economic uncertainty to send a clear and strong signal to investors that our business model is healthy," Coach CEO Lew Frankfort said at the time.

Daniel Peris, co-manager of the Federated Strategic Value Fund, says some CEOs will figure out that this is what investors want. "For others," he says, "the demands for higher yields will come as an unpleasant surprise."

You can no longer assume that you'll make most of your money in stocks simply by buying low and waiting for prices to climb. Dividends must play a prominent role in your strategy going forward.

But you don't have to reach for the absolute highest-yielding stocks. In fact, that's risky, since the reason that many stocks sport fat yields is not because they pay out so much, but because their shares have fallen so dramatically. Fortunately, there are plenty of solid bets yielding well more than the S&P 500 (see table, "Yielding more, but safely" ).

As you shift the focus of your portfolio from stock appreciation to total returns, follow these two steps:

Build in a greater margin of safety. The recession taught us that today's dividends aren't guaranteed to be paid tomorrow. A high-yielding stock might look good on paper, but that could be because management has been slow to cut payouts in the face of falling earnings.

So favor companies that have not only raised their dividends consistently for years, but have also boosted payments in the past six months. That's a sign of financial stability. This will bring you to firms like Clorox (CLX, Fortune 500), which has raised its payments every year for more than a quarter-century.

Also, go with stocks whose P/E ratios are below their five-year average, like the spirits maker Diageo (DEO). If P/E ratios are about to come under pressure, stocks that are trading at below-average valuations are likely to be less vulnerable because they're already cheap.

Broaden your search for dividends. Stock payments are a more ingrained part of corporate culture abroad. The MSCI EAFE index of overseas stocks, for example, currently enjoys a yield of 3.9%. That's more than a percentage point higher than the S&P 500, its U.S. counterpart. The easiest way to gain global dividend exposure is to buy a broad-based foreign-stock ETF, such as Power-Shares International Dividend Achievers (PID), which is currently yielding 3.5%.

And be willing to look beyond traditional groups. While more than 30 banks, brokerages, and insurers have slashed their payouts, consumer staples, energy, and tech stocks have stepped in with rising payments, a sign they're confident in their earnings stability (see table, "Where dividends are rising").

You may not be used to searching for dividend payers in these areas. But isn't that the point? If dividends become a pervasive trend in the broad market, they're likely to show up in unconventional places.