3 Reasons Dividend Stocks Are a "Must-Own"

Morgan Stanley's European Equity Strategy team recently published a note highlighting dividends' massive contribution to long-term stock returns. Arguing that dividends will only become more important in the next few years, the analysts compiled a list of high-dividend stocks with sustainable payouts.

While the report focused on European markets, it's easy enough to verify that the arguments apply equally to U.S. stocks. In this market, U.S. investors should focus on stocks that generate income.

The numbers don't lie: Dividends matter
The data leave no doubt about how much dividends have contributed to historical returns on European stocks -- particularly once those returns are adjusted for inflation:

European Stocks
(1926-2009)
Annualized Price Return
(w/o Dividends)
Annualized Total Return
(w/ Dividends)
Nominal 5.6% 9.6%
Inflation-adjusted 1.3% 5.2%

Source: Morgan Stanley Research.

As the following table shows, the equivalent figures for U.S. stocks over a broadly overlapping period are remarkably similar:

U.S. Stocks
(1926-2000)
Annualized Price Return
(w/o Dividends)
Annualized Total Return
(w/ Dividends)
Nominal 6.1% 10.7%
Inflation-adjusted 3% 7.6%

Source: Stock Markets in the Long Run: Participating in the Real Economy, Ibbotson & Chen (2002).

Why the past is prologue to the future
Will this phenomenon continue? The answer is "yes," according to the report; dividends will be an enduring driver of equity returns. In fact, Morgan Stanley believes that dividends are becoming more important, citing three separate reasons. Each also applies to U.S. stocks:

1. High demand for income.
As the baby boomers retire, income-related investment strategies become increasingly important.

Although U.S. demographics are more favorable than in Europe because of immigration, we should expect baby boomers in the U.S. to play the same role by favoring income strategies.

2. Less income competition from fixed income
According to Morgan Stanley, "yields on longer-term fixed income instruments are/will be higher [than short-term rates] but offer no protection against inflation and are vulnerable to the poor state of sovereign balance sheets."

With the 10-year Treasury bond yielding a miserly 2.56%, it offers absolutely no protection against the risk of inflation and highlights the attractiveness of a better-than-average dividend yield. Dividends increase over time, providing a hedge against inflation; Treasury bond coupons are fixed.

3. Range-bound market
Morgan Stanley expects European stocks to be stuck in a range-bound market over the next few years. It notes that in such markets, "income is more important than capital gains in driving total returns."

This is undoubtedly the most controversial of the three arguments. After all, stock prices are notoriously hard to predict. Nonetheless, a range-bound market in the U.S. is eminently plausible. I'd even say it's probable. Sure, we had a massive rally off the March 2009 low that lasted into 2010, but since early May, the S&P 500 has been trading in a 200-point range between 1000 and 1,200.

Five solid dividend payers
If you accept these arguments, you should be developing a healthy appetite for solid dividend-paying stocks by now. Here are five U.S. stocks with a dividend yield that significantly exceeds that of the S&P 500, and a dividend that has been tested for consistency and stability. All these stocks are part of Morningstar's Dividend Leaders index:

Company

Projected Dividend Yield

Dividend appears sustainable because:

Bristol-Myers Squibb (NYSE: BMY  ) 4.71% Solid prospects thanks to robust portfolio, successful partnering strategy, and a mountain of cash.
Conoco Phillips (NYSE: COP  ) 3.62% Oligopoly player in a vital industry
Exelon (NYSE: EXC  ) 4.87% Largest owner-operator of nuclear power plants in the U.S.
DuPont (NYSE: DD  ) 3.51% Tremendous intellectual property estate (18,000 patents!) and R&D capabilities and a focus on emerging markets/products.
Arthur J. Gallagher (NYSE: AJG  ) 4.82% Top 5 largest insurance broker with a middle market focus.

Source: Yahoo! Finance as of October 18, 2010.

It's worth emphasizing that the safety of a dividend is hard to assess. The credit crisis proved that even dividend stalwarts can falter.

In 2009, for example, Standard & Poor's removed 10 stocks from its highly selective Dividend Aristocrats index -- including BB&T (NYSE: BBT  ) and General Electric (NYSE: GE  ) . Both companies are on a path to restoring their dividends to pre-crisis levels, and I expect them to earn back their reputation as "workhorse" dividend stocks. But the same can't be said for all companies that cut their dividends during the same period.

Putting dividends in a portfolio context
Hopefully, I've convinced you that dividend stocks should be a part of your portfolio now. But let me be clear: "A part of" isn't the same as "all of" -- the decision should be made in the context of your broader portfolio. Emerging market stocks, for example, offer a hedge to some of the risks I described above -- and exposure to higher-growth economies.

Seeking opportunity in every corner of the market is what drives the Motley Fool's Million Dollar Portfolio, a real money portfolio that owns only the best stock recommendations from across the Motley Fool's different services. If you'd like to find out more about putting this "best-of-breed" approach to work for you, just click here.

This article was first published on March 19, 2010. It has been updated.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. Exelon is a Motley Fool Inside Value recommendation. The Fool owns shares of Exelon. The Motley Fool has a disclosure policy.


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