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Don't Forget About Dividends

Capital gains tend to grab the headlines but dividends are the hard-working silent partner in our stock portfolios

Alastair Kellett 22 February, 2013 | 9:41AM

This article is part of Morningstar.co.uk's Equity Investing Week.

In the world of equity investing, capital gains tend to grab the headlines. When most of us buy a stock, we dream about its share price quadrupling to give us an outsized profit on the deal. But dividends are the hard-working silent partner in our stock portfolios, chugging away behind the scenes and often adding up meaningfully over time and forming a large part of our total return. For those seeking a low-cost vehicle for diversified exposure to dividend-paying companies, a decent choice is the SPDR S&P US Dividend Aristocrats UCITS ETF (UDVD).

Launched in October 2011, this ETF has grown to a size of roughly $800 million. It carries a total expense ratio (TER) of 0.35% per year, which puts it in line with other ETFs focused on large cap, US equities. The underlying benchmark, S&P High Yield Dividend Aristocrats Index, has a dividend yield of 3.02%, compared to 2.19% for the broad S&P 500 Index. 

To be included in the S&P High Yield Dividend Aristocrats Index, companies must have increased their dividend every year for at least 20 consecutive years. So it's not just those stocks with the highest dividends right now, which can be risky if those payout ratios are unsustainable, but those stocks with lengthy records of dividend payments. 

The dividend focus of that index has led to strong performance relative to the wider universe of large-cap US equities. In the 10-year period through the end of January 2013, it produced a cumulative total return of 136.5%, versus 114.5% for the S&P 500. The performance has also been strong when we compare it to the S&P 500 Growth Index, many of whose constituents are at the opposite end of the spectrum, reinvesting most of their earnings rather than distributing them through dividends. In the same 10-year period the growth benchmark chalked up gains of 111.7%. 

Because of the dividend index's bias towards mature companies, such as Proctor & Gamble (PG) and McDonald's (MCD), with more consistent revenue and income, it's likely to outperform the broader market in times of stress. Indeed its biggest industry weight is consumer staples, which is considered a defensive sector, more "recession-proof" than others. Of course there will be periods when growth investing outperforms value, and stodgy dividend stocks may not keep up with the rest of the equity universe during raging bull markets. 

A "Bird in the Hand"

There are certain advantages to generous dividend policies. Having to pay out cash on a regular basis forces discipline on a company's managers, limiting their ability to pursue empire-building acquisitions that often end badly for shareholders.  Moreover, dividends represent a "bird in the hand"; an upfront return on investment that can be reinvested back into the company or put to work elsewhere, at the investor's preference. And a policy of increasing dividends signals to the market that management is confident in the firm's ability to continue generating cash from its ongoing operations, more so than a one-time special dividend or share buyback would. 

Of course, taking a bird in hand often means foregoing the chance at two in the bush. The drawback to a high dividend policy is that it limits the cash available for the growth of the company. That's why fast-growing firms like Google (GOOG) or Amazon (AMZN) typically pay no or scant dividends, and you won't find them in a fund like the SPDR S&P US Dividend Aristocrats. 

The debate about whether it is more advantageous for a company to have a cash hoard in its treasury or, in the absence of great ideas, to pay that money out to shareholders is currently playing out very publicly at Apple (AAPL). The tech firm has a massive amount of cash sitting on its balance sheet, and activist investor David Einhorn—who clearly takes the latter view—has launched a legal action that seeks to compel the company to distribute some of it. 

In today's environment of very low yields on bonds, equity dividends are a natural place to look for additional income, and investors of all stripes should strongly consider making room for them in their portfolios. Products like the SPDR S&P US Dividend Aristocrats and sister offerings SPDR S&P Euro Dividend Aristocrats (SPYW) and SPDR S&P UK Dividend Aristocrats (UKDV) make a good deal of sense, combining low costs with a methodology that ensures only the most consistent, reliable dividend payers are included, which should give us more comfort in the stability of the yield.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Amazon.com Inc305.46 USD2.14
Apple Inc108.00 USD0.95
Google, Inc. A567.87 USD1.36
McDonald's Corporation93.73 USD0.37
Procter & Gamble Co87.27 USD0.38
About Author Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.