Indeed, dividend-paying stocks are fast becoming the "bonds" of the future, with more than $5 billion having gone into funds that invest in them since October, according to fund research firm Lipper. And it's not just the same old names, like IBM and Johnson & Johnson, crowding the portfolio lineups; pros say there are also some great finds among smaller and more obscure firms. Many of these smaller fries are generating plenty of cash and have long records of paying or boosting their dividends, with yields that stack up well against most government bonds. But perhaps the biggest draw is how dividend-paying firms, especially those with a history of raising payouts, can withstand inflation, which can diminish a bond's value fast. With a bond, once you buy it, you are locked in at that rate. But with a stock, you could get a higher dividend.
Investors are beginning to buy the argument. While most stock funds had more money go out the door than they attracted in 2010, equity income funds, most of which concentrate on dividends, pulled in a total of $7.8 billion, according to Lipper. While many of those funds focus on the blue chip names, many smaller companies, from food distributor Sysco to asset manager Federated Investors, have been paying dividends for decades. In the sweet spot are smaller firms with a history of paying dividends and the wherewithal to boost the payouts in the future.
Some analysts expect dividend payouts to continue to increase this year, as pressure increases for firms sitting on lots of cash to do something with it. Yes, that means Cisco might use some of its nearly $40 billion in cash and short-term investments to pay a dividend, but smaller firms, such as retailer Kohl's, are also looking at instituting a dividend. More than half of the firms in the Russell 2000 small-cap index already pay dividends, bucking the common perception that smaller companies just plow all their cash back into their businesses to grow. Dividends in the small-cap world are really a well-kept secret.
Companies that pay dividends also tend to be less volatile. The payout signals that the firm's management believes their profits aren't going to disappear if the economy turns south. That puts these companies in an "elite class". In fact, over the past 20 years small-cap firms with a dividend outpaced their non-dividend-paying peers by an average of 14 percent a year. In contrast, large firms that paid dividends beat their non-dividend-paying peers by only 5.3 percent a year, according to financial research firm Ned Davis Research.
While bond investors might be tempted to buy stocks with the highest dividend yields, strategists recommend focusing instead on dividend growth potential and companies that are not yet paying out large amounts of their profits. Lofty payouts and yields also could be a sign of struggling companies.
To be sure, all stocks, even dividend-paying ones, can lose value. Small and midsize stocks also have been among the best market performers over the past two years. But the dividend payers in these groups have cheaper valuations than those not paying dividends, according to Ned Davis Research. Dividends from smaller firms are also slightly lower, on average, than those of larger companies. Mid- and large-size companies, for example, pay an average dividend of 1.4 percent, compared with 1.8 percent for large companies. But their average dividend growth rates are similar, with midsize and large companies alike increasing payouts by, on average, about 5 percent annually.
Considering that rising interest rates could swamp the bond market (bond prices move in the opposite direction of interest rates) and that the broad stock market is not cheap, strategists say getting income from different types of investments is key. You need all parts of your portfolio producing income.
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