Dividend investing: New benefits from a traditional strategy

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1 SM A RiverSource Institute Publication Dividend investing: New benefits from a traditional strategy High dividend yield: potential for return with less risk Since December 1969, the annualized return and risk, as measured by standard deviation, of the highest to lowest dividend-yielding quintiles reveal an interesting trend: The top two quintiles outperformed the others by a significant margin, with considerably less risk. Return 15.0% 12.5% 10.0% 7.5% Q1 15.0% Q2 Q3 17.5% 20.0% 22.5% Risk 25.0% 27.5% 30.0% Lehman Brothers Global Equity Research, September 26, Annualized return and standard deviation of highest (Q1) to lowest (Q5) dividend-yielding quintiles, equally weighted and rebalanced quarterly, since December Stock universe includes the largest 1,000 U.S. firms by market capitalization. Past performance does not guarantee future results. 1 Q4 Q5 The virtues of dividends have long been recognized by income investors, who traditionally have turned to dividend-paying stocks for their stability, income stream and price appreciation potential. But increasingly, high dividend-paying stocks are seen as an attractive choice for both income and growth investors. Reinvigorated by a change in tax laws giving dividends favorable treatment, dividendpaying stocks also stand to benefit from demographic shifts and the changing needs of the baby boomer generation. What s more, new research around suboptimal corporate behavior puts increasing pressure on companies to build shareholder value through dividends. This all spells good news for dividend investors, who stand to benefit as these trends gain momentum. High dividend-paying stocks: What history tells us Many investors especially those who first experienced a major stock market downturn from 2000 through 2002 have developed a new appreciation for the value of dividend-paying stocks. As a recent study from Lehman Brothers has shown, a steady stream of dividend income has enhanced total return with comparatively low levels of risk and provided a degree of downside protection, important considerations when the outlook for stocks is uncertain. 1 Focusing on stocks with yields that exceed the broader market may present the potential for competitive performance with a lower level of risk. 1 Source: Standard & Poor s, period January 1, 1936 through December 31, 2005.

2 Dividend investing Dividends may be especially advantageous during periods when equity returns dip below long-term averages. According to an analysis by Standard & Poor s, during the 25-year period ending December 31, 2005, there were five calendar years 1981, 1990, and the years 2000 to 2002 when the S&P 500 posted a loss. During these years, the S&P 500 lost an average of 10.22%, with nondividend-paying stocks losing materially more an average of 14.59%. Dividend-paying stocks, in contrast, gained an average of 1.14%, and their average yield was 3.20%. In effect, dividends acted as a counterbalance, providing investors with a degree of positive return. This potential to stabilize a portfolio is critical for investors who are amassing assets for retirement and other long-term goals. Inflation and tax considerations Recent surges in energy prices have prompted investors to focus more on outpacing inflation as a primary goal of their long-term financial planning, a trend that is likely to continue. Because increases in dividend payouts have surpassed inflation over the long term, dividend-paying stocks may be an effective hedge against inflation. Since 1936 through December 31, 2005, the dividend payout of the S&P 500 has increased at an average annual rate of 5.4%, surpassing the 3.9% average annual increase in the rate of inflation. 1 More recently, dividend income has offered important tax benefits. Legislation that took effect in 2003, and which Congress recently extended to 2010, reduced the federal tax rate on qualified dividends to 15%, enabling high dividend equity investors to keep a larger percentage of their return. Prior to the change in the law, qualified dividends received from U.S. corporations or certain foreign corporations had been taxed as ordinary income, up to a maximum of 38.6% for the highest income taxpayers in This drop in the federal tax rate on dividends equalized the rates assessed on dividends and long-term capital gains. Suddenly, investors had a powerful incentive to increase their allocations to high dividend-paying equities. Although there is still a tax deferral benefit to long-term capital gains, the bird in the hand feature of dividends makes them more attractive to many investors than volatile capital gains. The current 15% tax rate on qualified dividends is scheduled to expire after 2010, reverting after that to ordinary tax rates, unless Congress extends it. Yet the appeal of dividends goes well beyond tax rates. Regardless of Congressional action, the drive for dividends is likely to gain traction as changes in corporate behavior and demographic shifts increasingly stress the importance of dividends. The best use of corporate earnings Recent research by Robert D. Arnott and Clifford S. Asness suggests that higher dividend payouts and dividend growth mitigate the behavioral mistakes corporations are prone to make. Arnott and Asness examined corporate America s use of retained earnings and found that low payout ratios across the market resulted in lower-than-average future earnings growth. 2 This finding was directly opposite the conventional wisdom that earnings growth accelerates following periods of low dividend payouts. 1 Source: Standard & Poor s, period January 1, 1936 through December 31, Source: Financial Analysts Journal, January/February RiverSource Investments

3 To get to the heart of this apparent contradiction, the two researchers then analyzed economy-wide investment data to question management s insight into capital investing. Arnott and Asness found that as companies in aggregate increased investment, the subsequent earnings growth for the economy declined. In essence, corporations seemed to have a bias toward over-investing during times of high earnings growth and demonstrated a limited ability to forecast expected returns from new investment resulting in value-destroying investments. Following the dramatic decline in many segments of the U.S. stock market from 2000 to 2002, corporate America seems to have adopted a more sober outlook for investment. Capital spending trends, as a percentage of GDP, have remained at relatively low levels as earnings growth has strengthened. However, even as dividends have increased with earnings, payout ratios have not increased on average. Instead, corporations are stockpiling cash, paying down debt and announcing share repurchases. It therefore remains an open question whether corporate managers, on their own, will embrace the discipline inherent in a commitment to paying out more in dividends. However, thanks to the rise in shareholder activism, managements are being pressured to look beyond share buybacks. Following a series of high-profile corporate scandals, the issue of corporate financial discipline is likely to remain a key concern of investors. Armed with a heightened level of skepticism, investors are demanding a higher level of transparency in corporate earnings and are digging into corporate accounting with renewed vigor. Partly as a response to this heightened activism, companies are reacting by either initiating or increasing dividends. The following table illustrates the momentum of this trend. Dividends on the ascent Corporate America s interest in rewarding investors may be strengthening. With the overall economy and corporate profits experiencing healthy growth, many market observers believe this trend is likely to continue Dividend 1,949 (11.6% 1,745 (7% 1,630 increases annual increase) annual increase) One-time extra 544 (4.4% 521 (7.4% 485 dividends annual increase) annual increase) Dividend-paying 907 (3.6% 875 (4.1% 840 companies within annual increase) annual increase) the S&P 1500 Index Source: Standard & Poor s. This upward trend may signal continued momentum in the future. Because corporate management typically is reluctant to cut a dividend, the presence of a dividend, especially a rising payout ratio during periods of earnings growth, is a sign that management has a high degree of confidence in a company s long-term financial health, in particular the ability to generate cash flow. In the years to come, sustained high payout ratios combined with strong returns on invested capital may be the calling card of winning equity investments. RiverSource Investments 3

4 Dividend investing Room to catch up When monitoring high divided-paying yield equities, astute shareholders examine current dividend yield and payout ratio in relation to historical trends. A look back reveals that the recent yield of the S&P 500 is below its long-term average, leaving potential for upside. Of course, past performance does not guarantee future results. Yield 7% 6% 5% 4% 3% 2% S&P 500 dividend pay ratio S&P 500 yield Average yield 160% 140% 120% 100% 80% 60% 40% Dividend Payout Ratio 1% 20% 0% % Source: Standard & Poor s, period from January 1, 1960 ending December 31, A boost from the baby boomer generation The growing impetus to boost yields is also likely to come from a different quarter: the baby boomer generation looking for retirement income. According to an analysis by Morgan Stanley, the number of Americans between the ages of 60 and 69 is expected to increase between 4% and 5% annually during the next 10 years, compared with less than 1% growth for the overall population. As investors age they take on a fundamentally different approach to dividend investing. Morgan Stanley s 1998 Survey of Consumer Finances looked at IRS public-use data and found that the average taxable dividend yield on equity holdings was 2.6% for those over age 65. For comparison, the dividend yield was only 0.8% for those under age This demographic shift is significant because these older Americans will rely increasingly on income-producing investments such as dividend-paying stocks to fund their retirement. According to the most recent estimates, Social Security is likely to begin deficit spending in 2017, and by 2041, it will be able to finance only 74% of its expected annual benefits. 4 Compounding this expected shortfall, 4 RiverSource Investments 3 Source: Morgan Stanley U.S. Portfolio Strategy, A Brave New World, Henry H. McVey, March 31, Source: Social Security Office of the Chief Actuary, March 23, 2005.

5 significant numbers of pensions remain underfunded and recent announcements of plan terminations read like a Who s Who of corporate America. Corporations increasingly are turning away from traditional pension plans, which provided a pre-established benefit for life, in favor of defined contribution plans such as 401(k) plans that require employees to contribute and to make investment decisions. This confluence of events may leave tomorrow s retirees without the financial cushion that many of their parents enjoyed, prompting them to turn to their personal investments as their primary source of retirement income. In addition, given the longer life expectancies of tomorrow s retirees, there is reason to believe that dividend-paying stocks may play the role of a transitional asset within their portfolios. These equities offer much of the growth potential of stocks along with the income potential more often associated with bonds. Investors who will spend 20 years or more in retirement a strong possibility for someone who retires this year at age 62 will need to allocate a sizable portion of a portfolio to growth-oriented, higher expected return investments such as equity mutual funds that hold dividend-paying stocks. Demographic trends favor income-oriented investing As investors get older, their need for income causes their investment preferences to shift toward dividend-paying and interest-bearing securities. In 1998, interest and dividend income accounted for more than half of retirees investment income, compared with less than one-third for pre-retirees. This trend may accelerate going forward as today s pre-retirees and retirees grapple with a changing pension landscape, the pending insolvency of Medicare, and other factors that are likely to affect their retirement. U.S. elderly dependency ratio Elderly dependents (ages > 64) per 100 non-elderly Components of investment income Pre-retirees vs. post-retirees (1998) 35 Historical Census Bureau projections Capital gains, 69% Interest, 19% Dividends, 12% Pre-retirement Capital gains, 48% Interest, 30% Dividends, 22% Post-retirement Sources: U.S. Census Bureau Middle Series projections, Morgan Stanley Research. Sources: Internal Revenue Service Center for Data Analysis, Morgan Stanley Research. RiverSource Investments 5

6 Dividend investing The shift to equity income has already begun The preference for dividends is already becoming apparent as investors increasingly turn to equityincome funds. Inflows to equity-income funds totaled $26.6 billion and $21.7 billion in 2004 and 2005, respectively the second and third largest fund inflows in the respective years. Fund inflows ($ in billions) Equity fund categories International Equity $ 86.2 $ 57.9 $ 25.4 Equity-Income Global Equity Growth/Value-Aggressive Growth/Value-Large Cap All Equity Source: AMG Data Services, February High dividend-paying stocks: The wave of the future? Given their long history of steady returns, it may be easy to dismiss high dividend-paying stocks as an old story. But as legions of the baby boomer generation approach the end of their working lives, this steadiness may be the ingredient that will enable them to build wealth and absorb increases in the cost of living. Responding to this demand, corporations are likely to boost payout ratios, changing the face of equity investing for retirees as well as their working colleagues for years to come. 6 RiverSource Investments

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