Reaching for Yield: Aristocracy vs. Treasuries

The safety of an income stream -- even a tiny one -- and return of principal backed by the U.S. Treasury are attractive characteristics. However, with current puny yields, U.S. 10-year notes barely maintain purchasing power, and many investors are looking for more.

Dividend-paying stocks are one source for higher yields -- and higher risks. In an effort to quantify how much of a cushion the higher yield of stocks provides against those risks, let's have five stocks from the S&P 500 Dividend Aristocrats index run a 10-year discounted cash-flow gauntlet against Treasuries. Dividend Aristocrats are members of the S&P 500 that have raised dividends each year for at least 25 years. The index is a great shopping list for dividend growth investors.

The group of stocks was chosen by picking one high-yielding stock each from five of the 10 sectors represented in the index. The bar chart below shows the sector breakdown of the 51 companies in the index. The biggest surprise was that utilities, a sector known for dividends, has only one company in the index.

Source: S&P Dow Jones Indices LLC.

The contenders

Source: Yahoo! Finance; S&P Dow Jones Indices LLC; author's calculation. CAGR = compound annual growth rate.

Con Edison has been juicing up shares with a streak of dividend power-ups stretching back 38 years. Clorox shareholders have been cleaning up with dividends growing since 1977. Johnson & Johnson has kept stockholder accounts healthy with dividend raises every year for a half-century. Over at Emerson, the dividend control knob has been cranked higher for 55 years in a row. Meanwhile, dividend overhauls have boosted the payout horsepower at Genuine Parts for 56 years.

I have an outperform CAPScalls on Johnson & Johnson and Emerson. Both picks are up in absolute terms but trail the SPDR S&P 500 exchange-traded fund, the CAPS benchmark. A nice yield and a 56-year track record of payout increases earn Genuine Parts a place on my watchlist.

The match-up
The Treasuries and company stocks were compared using the net present value of the investment, coupon or dividend payments, and value at the end of 10 years. Since my crystal ball is a bit cloudy, the following assumptions were used to estimate the unknowns:

• Treasury yield is 1.75%, and the notes return full face value at maturity.
• Stocks start with their current dividend rate and raise the payment each year in the same quarter as the past several years. Dividend hikes are assumed to be either 75% of the past five year's compound annual growth rate or 8% -- whichever is less.
• Stock prices are assumed to be 10% higher at the end of 10 years -- less than a 1% compound annual growth rate.
• Future values are discounted at 1.7%, the most recent consumer price index rate reported by the Bureau of Labor Statistics.

The model was also run with no dividend growth in order to find how much each stock would need to lose over the 10 years for the Treasuries to come out ahead.

Results
No surprise that that Treasuries' purchasing power nearly flatlines with the yield near inflation, but it may surprise you how far the five stocks would need to fall before the notes come out ahead under these assumptions. The model also shows the importance of dividend growth to long-term returns. Con Ed starts out with the highest yield and the lowest average dividend growth rate. That lower growth lets three of the other four stocks in the model crank out better 10-year total returns.

Source: Author's calculation.

Summary
These aren't expected returns for the stocks; the scenario crimps dividend growth and assumes minimal growth in the stock price. The exercise is intended to compare several income streams and get a handle on the risks.

I have no idea whether these stocks can continue their aristocratic payout records or what bond yields and prices will do in the near term. That said, it's hard to see any likely scenario where long-term Treasuries at today's yields can outperform quality dividend-paying stocks over a period of many years.

Now it's your turn. Add a comment with your thoughts or a stock you'd like to see in a future match-up with Treasuries.

• Add Johnson & Johnson to My Watchlist.
• Add Genuine Parts to My Watchlist.
• Add Emerson Electric to My Watchlist.
• Add Consolidated Edison to My Watchlist.
• Add Clorox to My Watchlist.