Finance Over the Last Several Years, Dividend

Finance

Over the last several years, dividend stocks have become an important tool that is helping investors to realize above average returns. According to Paul (2012), these areas have been accounting for 40% of profits on the Dow Jones Industrial Average since 1930. This is because they can provide a number of benefits in assisting investors to realize their long-term objectives with him saying, "Those areas that offer sustainable and growing dividends hedge income streams against inflation, to provide growing income to investors without the need to sell shares and to signify strength to investors. These firms generally exhibit lower stock price volatility, while delivering attractive and even superior returns." This is illustrating how these kinds of securities can provide protection, lower amounts of volatility and higher returns to investors. (Paul, 2012)

In 2012, these returns have been greater for those companies in contrast with growth areas (such as the Russell 2000). The below table is comparing these returns with the dividends that were received from the firms listed on the Dow Jones Industrial Average (which paid dividends).

Russell 2000 Growth Companies vs. The Dividends Paid on the Median Return for Dow Jones Industrial Average Dividend Stocks

Index

2012 Return

Dow Jones Industrial Average Dividend Stocks Performance and Income

10.0%

Russell 2000

9.58%

("Russell,"2012) (Arends, 2012)

These figures are illustrating how the total returns are higher in contrast with companies that are focused on growth (which pay no dividends).

Introduction

A common challenge that all investors will face is finding asset classes that can reduce their risk, increase income and offer capital appreciation. Those companies that are paying dividends are considered to be more established and they have track record of delivering consistent earnings. As a result, the different corporations with the highest yields on Dow Jones Industrial Average include: AT&T, Verizon, Intel, Hewlett Packard, Du Pont and Merck. These firms are paying between: 3.79% to 5.24%. ("Dow Jones Industrial Best Dividend Stocks," 2012) Moreover, they are yielding an average return of 10% for 2012. (Arends, 2012)

When this is compared with other investment classes, these figures are much greater. Evidence of this can be seen in the below table (which is contrasting the average divided growth rate with certificates of deposit and U.S. Treasuries).

Return of Dow Jones Industrial Average Dividend Stocks in Contrast with CDs and U.S. Treasuries

Category

Return

Dow Jones Industrial Average Dividend Stocks

10.0%

CDs

2.35%

US Treasuries

2.68%

Corporate Bonds

4.68%

(Arends, 2012) ("Current Rates," 2012)

These numbers are showing how dividend stocks are providing a larger return in comparison with other asset classes. For investors, this is illustrating how they have fewer opportunities to receive consistent amounts of income without increasing the risks exponentially. To fully understand what is taking place, there will be a focus on: dividend paying firms in comparison with other areas, top performing dividend industries, the weaker dividend sectors and if a bubble is developing in these securities. Together, these elements will highlight if the value of these stocks are inflated in contrast with their fundamentals.

Dividend Paying Stocks in Contrast with Other Popular Investments

The biggest reason why dividend paying stocks have risen in popularity is because interest rates are sitting at historical lows. This is because the economy has been facing considerable challenges and the Federal Reserve is trying to stimulate growth by reducing them to such levels. For investors who are purchasing CDs, this is problematic as they will be unable to receive a positive return (when taxes and inflation are taken into account). (Stein, 2005)

Evidence of this can be seen by looking at the yield on CDs. In 2002, everyone could earn interest of 6.20% on these investments. As the economy collapsed, many of the yields were steadily declining to prevent it from falling into a depression. During this process, is when the total returns in these areas decreased to the point that many investors were realizing negative returns (with them sitting at 2.35%). (Stein, 2005) ("Current Rates," 2012)

For retires and individuals that wanted to have increased amounts of income, they began to invest in Dow stocks (which paid more than what they were receiving in CDs). This meant that their focus shifted from purchasing these areas to those companies which could offer higher yields and growth. Evidence of this can be seen with observations from Carrel (2010). He found that there are several major advantages of investing in dividend stocks to include: passive income, improved total returns, reduced risks (from purchasing more stable companies) and continued ownership while collecting profits. This is significant, in illustrating how this asset class has become more popular based upon: the low interest rates, reduced risk and the ability to realize a larger return. As a result, investors have been focused on locating assets classes that can provide them greater returns without increasing the overall amounts of risk. Dividend stocks are one of the highest yielding areas that can achieve these objectives. (Carrel, 2010) (Stein, 2005)

At the same time, the yield on U.S. Treasuries is sitting at 2.68% and investment grade corporate bonds are 4.68%. In the case of U.S. Treasuries, these amounts are similar to what is provided with CDs. This means that investors will receive negative returns in this asset class. (Stein, 2005) ("Current Rates," 2012)

While corporate bonds, are paying higher amounts of interest. However, the risks increase exponentially based upon the potential that the firm will default. In those situations where the corporation has a higher rating for credit worthiness; the yields will be closer to what is offered by U.S. Treasuries. This is illustrating how these investments pay a little bit more. Yet, they do not offer the same kind of potential returns as divided stocks. These factors are showing how investors want something that will offer them with the best returns and the least amounts of risk. In order to achieve these objectives, they have been turning to this asset class as a way to enhance their performance and reduce volatility. At the end of the year, this will provide them with more balance, diversification and a greater total return. (Stein, 2005) ("Current Rates," 2012)

Another area that could be considered is fixed annuities. These are insurance contracts that can provide investors with a guaranteed return that is not tied to the stock market. In general, the problem with investing in this asset class is they are illiquid with various stipulations (such as: surrender charges over a select period of time). This can hurt their return and ability to have access to the money. For many investors; dividend stocks offer greater yields, larger returns and more liquidity. (Petcher, 2011) These factors are highlighting why many individuals are turning to these kinds of securities and the reasons they have become so popular in the last few years.

Top Dividend Performing Industries

There are many different industries that are considered to be the highest dividend payers with the lowest amounts of risk. Looking at the stocks listed on the Dow Jones Industrial Average there are a number of sectors that fall into a host of categories. The below table is highlighting the different companies with the largest yields in contrast with their industries.

Dow Stocks with the Greatest Dividends and their Industries

Company

Yield

Industry

AT&T

5.24%

Telecommunication

Verizon

4.71%

Telecommunication

Intel

4.56%

Technology

Hewlett Packard

4.24%

Technology

Du Pont

3.99%

Chemicals

Merck

3.79%

Pharmaceuticals

Pfizer

3.59%

Pharmaceuticals

McDonalds

3.54%

Food Service

Johnson and Johnson

3.51%

Pharmaceuticals

Chevron

3.41%

Oil and Gas

Microsoft

3.32%

Technology

Proctor and Gamble

3.23%

Consumer Durables

GE

3.23%

Industrial Goods

("Dow Jones Industrial Best Dividend Stocks," 2012)

These figures are showing that there are many different sectors which are offering solid dividends and increasing value. The most notable include: technology, oil / gas, industrial goods, pharmaceuticals, consumer durables, food services, chemicals and telecommunications. ("Dow Jones Industrial Best Dividend Stocks," 2012)

However, outside of the Dow Jones Industrial Average are other sectors that will have high yields with low amounts of risk. Most notably, electricity and natural gas distributors / producers are industries that fall into this category (which is illustrated in the below table).

High Yielding Electric Utilities and Natural Gas Distributors

Company

Yield

Industry

Atlantic Power

9.56%

Electricity

Trans Atla Corp.

7.59%

Natural Gas

Exelon

7.35%

Electricity / Natural Gas

Gas Natural

5.84%

Natural Gas

Pepco Holdings

5.65%

Electricity / Natural Gas

Ameren Corp.

5.60%

Electricity / Natural Gas

Unitil Corp.

5.54%

Electricity / Natural Gas

TECO Energy

5.43%

Electricity / Natural Gas

First Energy

5.36%

Electricity

("Utility Common Stocks," 2012)

These figures are showing how electricity and natural gas stocks are providing higher yields to investors with reduced risks. This is because these firms have a commodity that is continually in demand regardless with what is happening with economy. As a result, this means that they have more consistent earnings and can offer investors with greater amounts of appreciation and protection. ("Utility Common Stocks," 2012)

Those firms with rising dividends and solid fundamentals include: technology, oil / gas, industrial goods, pharmaceuticals, consumer durables, food services, chemicals, electricity / natural gas producers as well as telecommunications. This is illustrating how these industries have select firms that can provide investors with reduced amounts of risk and greater appreciation. The higher yields and the potential for greater rewards are what have been leading to more demand. ("Utility Common Stocks," 2012) ("Dow Jones Industrial Best Dividend Stocks," 2012)

Dividend Weaker Performing Industries

However, despite the strong yields and consistent earnings with many dividend stocks, there are select firms that have trouble maintaining these high levels. This is because some companies are using dividends to entice investors to become interested in the firm based upon the large yield they are offering. Yet, they do not have a consistent track record of paying and increasing these amounts. (Graham, 2005) (Hutchinson, 2012)

This is problematic, as some firms will have instability in these areas from their exposure to changes in the economy or within their business. According to Graham (2005), this type of investment will more than likely result in higher amounts of volatility and risks. The reason why is because they do not have the earnings or cash flow to continue paying investors at these levels. When this happens, there is a high probability that the dividend payout will be reduced and the price of the stock will decline. (Graham, 2005) (Hutchinson, 2012)

There are several different sectors that fall into this category. The below table is highlighting those companies that have declining yields and earnings.

Stocks with Declining Dividends and their Industries

Company

Yield

Industry

Great Northern Iron Ore

19.70%

Basic Materials

Whiting USA Trust

38.00%

Oil / Gas

BP Prudhoe Bay Trust

9.60%

Oil / Gas

Frontier Communication

8.90%

Telecom Service

American Capital Agency Corp.

15.80%

Residential REIT

Annaly Capital Management

13.60%

Diversified REIT

Chimeria Investment Corp.

13.70%

Diversified REIT

(Hutchinson, 2012)

These figures are showing how a host of industries are seeing declining yields. This is because, these firms have balance sheets with high amounts of debt, there are declining earnings and the company could be paying a large one time pay out (which increases the annual dividend). In some cases, this is taking place with companies in industries that have competitors who are increasing these amounts (such as: oil / gas and telecom). While at other times, this will impact basic materials and real estate investment trusts. (Graham, 2005) (Hutchinson, 2012)

This is illustrating how all firms paying dividends are not the same. The reason why is because the firm's balance sheet, their earnings and cash will determine if they can continue paying these amounts. A good example of this can be seen with observations from Hutchinson (2012) who said, "If an investor shops by yield and yield alone, they are playing a dangerous game. It's called picking up nickels in front of a steamroller. Admittedly, it may work for a while, but eventually the steamroller will prevail. That's why in today's low-growth environment, it's critical to know which dividend stocks not to buy. Avoid the real duds and the dividends alone will be enough to bail them out of minor mistakes. Those who find themselves on the wrong side of the fence and in high-yielding investments could end up being pretty costly. Prudent investors need to avoid dividend stocks where the source of income will dry up in a few years, and the dividend payout doesn't add up to the valuations they are paying for the stock." (Hutchinson, 2012)

This is illustrating how not all dividends are the same. The main reasons are from a slow economy impacting their earnings and free cash flow. At the same time, the dividend yield could be so large in contrast with the price of the stock that it is unstable. When this happens, there is a possibility that the company will begin making less money (which is resulting in a decrease in their bottom line results). This is the point that the management will cut or eliminate the dividend to shareholders. Once this takes place, there will be a decline in share prices and the investment will produce negative returns. (Graham, 2005) (Hutchinson, 2012)

The Dividend Bubble

There is value that can be found in many dividend paying stocks. This is because select firms have rising earnings, tremendous amounts of cash, products that are in demand, low levels of debt and a track record of paying their dividends going back many years. The combination of these factors is helping them to provide consistent returns to investors in the form of yields and through the potential for long-term price appreciation. (Graham, 2005)

For example, a quick analysis of the highest paying companies on the Dow Jones Industrial Average are showing how they have large amounts of cash, increasing earnings per share and low amounts of debt. Moreover, they are offering products and services that customers are demanding. According to Graham, this reduces the long-term volatility in these stocks and the risks of investing in them. This allows investors to reduce their risks by knowing that these kinds of companies can deliver on their bottom line results and increase yields. When this takes place, they will see lower amounts of risk and volatility. At the same time, they will realize the potential for long-term appreciation. This increases the total returns that they are receiving (which represents value in these investments). (Graham, 2005)

However, there are also many companies that are dividend traps. This is because they are paying out high yields to their shareholders. But, they have large amounts of: debt, declining earnings and an inconsistent track record of maintaining these levels over many years. For numerous investors this can lead to substantial losses. The way that this is taking place, is through exclusively purchasing the stock based upon the yield. When this happens, the odds increase that the company will cut the dividend and the price will fall. (Graham, 2005)

As a result, there is value that can be found in dividend paying stocks. The key is being able to identify those areas that can provide consistency in these amounts, have rising earnings, selling products that are in demand, low amounts of debt and high levels of free cash flow. This is the sign of a firm which has the financial stability to continue to maintaining these levels in the future. (Graham, 2005)

Moreover, they can increase their earnings which will provide investors with the ability to see long-term capital appreciation. When these elements are put together, the total return will be higher for these areas. While, the risks of seeing volatility is decreased from the financial condition of the company. Those investors who follow this basic strategy will see above average performance (based upon these factors working together). Therefore, everyone should carefully analyze the fiscal state of the company and their ability to maintain these levels. (Graham, 2005)

However, those who do not follow this basic philosophy will realize greater amounts of volatility and declining yields. This means that valuations can be found depending upon the firm and their ability to maintain these payouts. Any kind of assessment will be based on a case by case basis for each company that is being examined. (Graham, 2005)

Conclusion

Clearly, the research is showing that the value for many dividends stocks has been inflated. This is because investors have nowhere else to find higher yields. At the same time, the aging demographics of the population and lower amounts of growth are pushing them to seek out these securities. This has caused the prices of these stocks to increase in value. (Graham, 2005)

However, each company is different and has contrasting balance sheets / dividend payout consistency. Those firms with lower amounts of debt, high levels of free cash flow, rising earnings and products that are in demand can provide stability / capital appreciation. This is because they have the fundamentals to support their activities and the yields provided to shareholders with better returns. (Graham, 2005)

As a result, everyone should carefully examine the balance sheet and the company's ability to maintain these amounts. When this happens, investors can reduce their risks and improve the overall return. Those who not are taking this approach, will more than likely find that these stocks are an asset bubble that will burst. This is the point that they will see significant declines in these areas. (Graham, 2005)

Lastly, (after the conclusion) on a separate page write a separate paragraph stating clearly and concisely your position on where the following markets will be by Dec 2017 -- (essentially a forecast) and why?

In 2017; the Dow Jones Industrial Average, NASDAQ and Global Dow will be moving toward their all-time highs. This is because the economy dealt with the fiscal challenges associated from: government / consumer spending, housing and the U.S. will become one of the largest oil producers. These factors will give investors a sense of confidence about the future (which is creating significant valuations with the ability to see long-term price appreciation). (Mullaney, 2012)

While the Federal Funds Rate, 10-year Treasury notes and DJ Corporate Index will have higher yields (i.e. around 3.0% to 4.0%). The reason why is because interest rates are at historic lows. Any kind of improvement in the economy will result in the Federal Reserve raising these amounts. When this happens, these levels will increase to historical averages. This will result in these markets having a selloff from rising rates (which is leading to investors driving down the prices of lower yielding securities).

However, given the fact that the economy is improving, this will result in these rises reflecting the need for the Federal Reserve to reduce the total amounts of liquidity. The only way that this can take place through: increased economic activity, declining unemployment and the potential that cost push inflation is emerging. This will force the central bank to raise interest rates (leading to higher yields). Yet, the underlying amounts are at low enough levels that they will not hurt economic activity. Instead, they will create a perfect balance between the different markets. This allows economic activity to increase (which is leading to an improvement in the equity markets).

Review

Research Objectives

Since 1930, dividend paying stocks are accounting for 40% of the total profits on the Dow Jones Industrial Average. This year they are outperforming growth companies by showing a return of 10.0% in contrast with 9.58%. This study will focus on specific industries and firms that have the ability to provide superior returns in contrast with other areas.