Morningstar Advisor - October/November 2011 - (Page 25)

In Practice Risks of Stretching for Yield By John Owens Investors can minimize dangers by showing a little moderation and focusing on fundamentals. With money markets, CDs, and Treasuries offering little to no yields in nominal terms and negative yields in real terms, many investors are considering other sources of income, such as dividend-paying stocks. Even PIMCO’s Bill Gross, manager of the world’s largest bond fund, expressed his preference for blue-chip, dividend-paying stocks over Treasuries at the 2011 Morningstar Investment Conference. Based on our research and experience, we think Gross is onto something: A portfolio of high-quality, dividend-paying stocks not only offers the potential for higher yield versus cash and fixed-income alternatives, but also offers the prospect for growth in income and capital appreciation. The historical record also bears out the success of dividend investing: From 1926 to 2010, the geometric mean return, including reinvestment of dividends, from large-company stocks averaged 9.9% per annum, trumping long-term corporate bonds, long-term government bonds, and U.S. Treasury bills at 5.9%, 5.5%, and 3.6%, respectively, based on data compiled by Ibbotson Associates. Empirical Research Partners, a provider of research to institutional investors, also determined that dividendpaying stocks have outperformed non-dividendpaying stocks in four of the past five decades. Dividend-paying stocks can also offer more-advantageous federal tax treatment. Christine Benz, Morningstar’s director of personal finance, notes that through 2012, investors in tax brackets of 25% or above will pay just 15% on qualified stock dividends, and those in the 10% or 15% tax brackets will pay nothing. Income from Treasuries and corporate bonds, by contrast, are taxed at the investor’s ordinary income tax rate. That said, investing in dividend-paying stocks is riskier than investing in bonds. Consider that the Morningstar Dividend Leaders Index, which includes the 100 highest-yielding stocks that meet Morningstar’s dividend consistency and sustainability screens, declined by 14% in 2007 and by another 35% in 2008. Given this kind of volatility, a portfolio of dividend-paying stocks can be a very poor substitute for cash and fixed-income investments, especially when aiming to fund short- to medium-term liabilities. So, this strategy of investing in dividendpaying stocks is only suitable for risk-tolerant investors with long-term investment horizons. Reaching for Yield in Stocks sheets and low levels of cash flow to support future payments. Washington Mutual was the highest-yielding large-cap bank stock in late 2007, just before slashing its dividend and ultimately filing for bankruptcy. So, it should come as no surprise that avoiding companies with unsustainably high dividend yields has historically provided higher returns for equity investors. According to Ned Davis Research, from January 1972 to December 2010, shares of S&P 500 firms that cut or eliminated their dividend delivered a negative 0.5% annualized return, versus a positive 9.6% return for dividend growers and initiators, 7.5% for dividend payers with no change in dividends, and 1.7% for non-dividend-paying stocks. Seeking a Better Way Stretching for yield within the equity market bears its own set of risks. A stock with a high dividend yield may indicate that there is limited potential for income growth or even worse, the prospect of a cut or elimination of the dividend, which generally leads to very poor returns for shareholders. This is especially true for companies with weak balance We also see potential for superior returns outside of the equity market’s highest-yielding stocks. Our analysis split the members of the S&P 500 into five quintiles, based on their forward dividend yields (with the first quintile representing the highest-yielding stocks and the fifth quintile representing the lowest-yielding stocks) and then ranked the quintiles, based on seven different valuation metrics (Exhibit 1). Price/Fair Value Estimate First, we examined the median price to Morningstar’s fair value estimate within each quintile. (The Morningstar fair value estimate is MorningstarAdvisor.com 25 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2011

Morningstar Advisor - October/November 2011
Contents
Contributors
Letter From the Editor
The Emotional Burden
Where Are You Going for Yield?
Ahead of the Curve
How to Use a ‘Collar’
Why Dividends
Is Bond Investing All Uphill From Here?
Four Picks for the Present
Investment Briefs
The Risks of Stretching for Yield
For Banks, Uncertainty Reigns
The Virtues of Dividends
How Well Do You Know Templeton Global Bond?
The Case for Dividends in Emerging Markets
Finding Refuge in Value
Swift, Smooth, and Silent
Crack Open Closed- End Funds to Avoid the Relevance Paradox
Getting Beyond Labels in the ‘To vs. Through’ Debate
Handling the Headwinds
Bonds, Short-Term Bonds
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
A Prisoner of Pricing

Morningstar Advisor - October/November 2011