Tuesday, May 19, 2009

* Dividend Investing in a Bear Market

Dividend stocks have long been considered defensive stocks - those that you buy when the economy and the market go south. While everyone else is panicked about their portfolio’s decline, dividend investors see a downturn as an incredible buying opportunity.

Recently, Steven F. Shepich, a professional money manager with Ameriprise Financial sent me a white paper he wrote back in April titled "Dividend Investing in a Bear Market." I found it very interesting and when asked if I could share it with my readers, Steven graciously consented. Below are some highlights of the white paper:
We are currently in a cyclical bear market (since October 2007) and a secular bear market (since 2000).

As of March 31, 2009 the price level of the S&P 500 Index was down 40% over the last year and 38% below the level it traded at ten years earlier. This is a strong indication that we are in both a cyclical bear market and a secular bear market. A secular bear market will begin at historic high earnings multiples and usually occurs during long-term periods of stress, turmoil, and political changes. Historic events such as World War I, the Great Depression, World War II, the Vietnam War, the fight for civil rights, and the 1970s oil embargo, all occurred during secular bear markets. In periods like this, investors’ long-term views are less optimistic, which results in a long-term downward trend in market valuations. A secular bear market will usually contain one or more major market corrections. Secular markets are different than cyclical markets which are shorter-term (one to five years) and usually revolve around the rise and fall of the economic cycle. Cyclical markets reflect economic changes in corporate earnings, while secular markets reflect long-term trends in valuation. Secular markets often contain multiple cyclical markets. For example, the crash of 1987 and the 90-91 recessions occurred during our last secular bull market (1982 – 2000).

We believe a dividend-based investment approach can be an effective strategy in secular bear markets for long-term investors.

We have just experienced the largest single year market decline since the Great Depression; the economic news appears to be moving from bad to worse; and there is a large degree of uncertainty going forward. Couple with this the fact that we are in a long-term secular bear market which could last another 10 years or more; the question becomes ….Why be invested in the market at all?

A dividend based investment approach involves investing in a diversified portfolio of stocks that provide stable dividend payments at attractive yields. Dividends provide income in down and flat markets, which can be reinvested and compounded over time. Furthermore, we believe significant cyclical market declines provide a unique investment opportunity for dividend oriented investors with a long-term time horizon. Dividends provide income in down and flat markets, which can be reinvested and compounded over time.

In our opinion, significant cyclical market declines (like the current one) provide a unique investment opportunity for dividend-oriented investors:
  • Market pullbacks create attractive dividend yields and new high-yield opportunities.
  • Reinvesting dividends from stocks with attractive yields can have a material positive impact on long-term returns even in a flat stock market.
  • Dividend reinvestment in stocks selling at depressed prices can significantly enhance capital gain potential when the market eventually moves into recovery mode.
Dividends provided a significant benefit to long-term investors during and following the Great Depression.

It took more than 25 years (1929-1954) for the market to get back to the level reached before the 1929 crash. Including dividends in the equation tells a much different story. In fact, during the 25 year period that it took stock prices to get back to break-even, an investor who invested $100K and reinvested dividends would have seen his portfolio grow to $431K (a return of 331%).

Dividend stocks have out-performed the S&P 500 since the beginning of the current secular bear market.

Over the last nine years (3/00 – 3/09), the total return for the S&P 500 was negative 37.4% (-5.1% annualized), while the DJ Dividend Index had a total return of positive 34.0% (3.3% annualized). This leads us to conclude that the core cash return that dividends provide become more of a relevant factor in periods of multiple contraction (secular bear) than in periods of multiple expansion (secular bull).

What Have You Done For Me Lately?

Investing in stocks was a bit different in the 30’s than it is today. Back then, dividends were expected by investors and payout ratios were high, relative to today’s standards. The average yield during the 20s and the 30s ranged between 5% and 9%. During the last secular bull market (1982-2000), dividend yields gradually declined to an all time low, as valuations increased and investors became more interested in capital gains, to the point that in 2000 the dividend yield on the S&P 500 was barely over 1%.

According to return data obtain from Bloomberg, over the last seventeen years (3/92 – 3/09) the S&P 500 Index provided an annualized total return of 6.1%. During the same period the Dow Jones US Select Dividend Index (DJDVY) posted an annualized return of 8.9%. Put another way, a $100K investment in the DJDVY would have grown to $424K during that period, compared to $276K had it been invested in the S&P 500.
These were just some of the highlights, you can click here to read the entire report.

So how would five select individual dividend stocks that are in most every dividends investors portfolio fared against the S&P over the last two years? This chart compares the S&P 500 (VFINX) with:

The above chart (click to view full size) only considers the capital appreciation element. The table below layers in the effect of dividends:
Dividend Adj. Prices
5/8/2007 5/8/2009 % Chng
VFINX 132.88 125.53 -5.5%
JNJ 60.23 64.92 7.8%
PG 58.77 64.09 9.1%
KO 50.12 54.48 8.7%
MCD 46.29 57.97 25.2%
WMT 46.35 56.13 21.1%
Good solid dividend stocks will not always out-perform the S&P 500 (see this year-to-date for example), but consistent and rising dividends certainly gives dividend stocks a head start.

Full Disclosure: At the time of this writing I was long in VFINX, JNJ, PG, KO, MCD, WMT. I received no compensation from Steven F. Shepich or Ameriprise Financial for writing this article. (view my income holdings)
(Photo Credit)

Tags: [JNJ] [KO] [MCD] [PG] [VFINX] [WMT]