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Dividends really do make a difference

After losing favor for a number of years, dividends are regaining importance in investing

After losing favor for a number of years, dividends are regaining importance in investing. For many stock pickers, myself included, it isn’t surprising.

Yields on traditional fixed-income assets remain at historic lows, making it increasingly difficult for investors to generate and maintain a meaningful income stream. In a historically unique scenario, yields on dividend-paying global equities rival those of traditional fixed income.

The MSCI EAFE Index had a yield of 2.9% as of Dec. 31, compared with the 10-year U.S. Treasury yield of 3.3%.

Dividend payers pack a double punch. In addition to providing income, they have outperformed on a total-return basis.

Studies have found that 90% of U.S. equity returns over the past century have been delivered by dividends and dividend growth, illustrating the significant impact of sustained cash returns, coupled with the compounding effect.

Why the impact? It relates directly to the underlying strength of the issuing company.

Dividend-paying companies require a strong balance sheet, healthy cash flow and disciplined management to maintain and increase their dividends. This has proved to pay off for investors on absolute, relative and risk-adjusted bases.

On a global basis, stocks that pay a high dividend and increase that dividend over time have been able to outperform the broad market over the long term.

Income-oriented equity investing is supported by the record amounts of cash on corporate balance sheets. In my experience, one of the most effective ways to capitalize on this is to invest in those companies that return a significant portion of that cash to investors in the form of dividends.

Attractive stock market valuations sweeten the pot. Compared with other asset classes, equities in general are bargains, but high-dividend stocks have been even cheaper than low-dividend stocks.

Fund flows show investors moving out of low-yielding fixed-income assets and back into higher-yielding, high-quality stocks.

This may signal recognition that dividend-paying equities really do make a difference when it comes to addressing three of the biggest issues that investors face:

Investors are underinvested in equities and overinvested in cash and fixed income. It is time to switch, and high-quality, low-volatility dividend payers are a good place to start.

The slow-growth, low-yield environment appears likely to persist for some time. Focusing on income-oriented equities, with international exposure to tap growth in the developing world, represents an attractive option.

Inflation protection is likely to become a larger issue in 2011 and beyond. This is true not because inflation is likely to run rampant but simply because investors are likely to grow increasingly concerned about it. Dividend-paying equities offer that sort of protection.

However, it is important to remember that not all dividend payers are created equal. Merely choosing companies that offer the highest yields isn’t an effective, risk-aware approach, as not all dividends will prove sustainable.

That said, what are some ways to play the dividend opportunity?

Focus on sectors with attributes that are generating opportunities for yield.

Such sectors include those facing pressures that create relatively low-priced income opportunities such as telecommunications and pharmaceuticals, as well as sectors that have proved recession-proof and offer growth even during tough times.

Look for companies that have a sustainable business model, a strong financial position and an above-average dividend.

Don’t fail to look beyond the United States. According to Société Générale SA, over the past 30 years, greater than 90% of stock returns in France, Germany and the United Kingdom have come from dividends and dividend growth.

Selection of equities with high potential for sustainable dividends demands careful analysis. For many clients, an income-focused fund with a demonstrable, superior long-term record will offer the greatest comfort.

Richard Turnill is a managing director and heads the global equity team at BlackRock Inc. He also is a portfolio manager of the BlackRock Global Dividend Income Fund.