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:

Source: Morgan Stanley Research.

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

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."

This argument won't hold up indefinitely, especially now that the current Greek crisis has put the ragged state of sovereign balance sheets in developed economies front and center. At some point, investors will demand higher yields on government bonds to compensate them for inflation risk. (Or outright default risk!)

However, because the dollar is the world's reserve currency, the U.S. will be able to defer this scenario longer than most European nations; I don't expect it to materialize in the immediate future. In the meantime, low bond rates -- the 10-year Treasury bond yields just 3.88% -- offer little or no protection against these risks. In that context, a better-than-average dividend yield looks relatively more attractive as dividends increase over time, providing a hedge against inflation.

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.

Two exits from the "running of the bulls"
In the course of the massive rally off last year's March low, stock prices have gotten ahead of themselves, and are now discounting a strong economic recovery ... of which we have seen little to no evidence, with plenty to the contrary. Inveterate bulls would say that stock prices themselves are the only necessary evidence of an imminent, powerful uptrend in economic activity. I'm decidedly skeptical.

There are only two ways in which stock valuations can come back in line with stocks' earnings power: A correction in prices, or stagnating stock prices for an extended period during which earnings play catch-up with valuations. In either scenario, dividends become relatively attractive.

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:

Source: Morningstar
*As of March 25, 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 General Electric (NYSE: GE) and US Bancorp (NYSE: USB). Both companies are on a path to restore their dividends to precrisis 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.

The linchpin of a dividend strategy
To implement a dividend-oriented investing strategy, you must identify genuinely sustainable payouts at the very least. If they can grow, that's even better. This is no easy task; even Morgan Stanley admits that this criterion is "somewhat subjective." Judging a dividend's sustainability requires a mix of quantitative and qualitative analysis, which requires judgment, experience, and time.

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Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Pfizer and Waste Management are Motley Fool Inside Value recommendations. Kimberly-Clark and Waste Management are Motley Fool Income Investor selections. The Motley Fool has a disclosure policy.