Dividends - And old answer to a new problem By Sanjay Arya, Director of Morningstar Indexes and Jeff Strazis, Product Manager of Morningstar Indexes

Once considered boring and stodgy, dividend-paying stocks are enjoying renewed attention from investors. Take the bear market that ushered in the new millennium, historically low bond yields, and Congress’ 2003 decision to give favorable tax treatment to dividends, add in the income needs of the baby boomer generation and it’s not hard to see why.

This demographic tsunami of 60 million soon-to-be retired investors is grappling with one overriding question – “How do I invest my savings to provide income for the rest my life?” The answer is simple enough - a diversified, low volatility portfolio that provides an inflation-protected stream of payments. Implementation is the tough part. The implication for financial advisors is profound.

The challenge of building a financial plan that stretches across a 30-year horizon has called some traditional thinking around risk tolerance and asset allocation into question. While there is no denying the need for new ideas and products, at least one tried and true investing basic is deserves consideration – dividend based investing.

The Case for Dividends

Dividends are one of the few constants in the world of investing, contributing about a third of the stock market’s total returns historically. Dividend-paying stocks offer solutions to a host of investment problems by providing:

• More predictable returns — Over long stretches of time, a stock’s return tends to correlate to its dividend yield plus subsequent dividend growth. In any given year, other factors — earnings swings, market fads—can overwhelm this rule. But, over a longer time horizon, these cyclical variations smooth. The more predictable dividend payments are the more likely returns will stay in a predictable range.
• Lower volatility — Companies with strong dividend policies often operate in stable markets and produce large, predictable free cash flows. When the bulk of a stock's total return is built with steady dividends, there's less reason for investors to obsess about earnings estimates, management soap operas, merger rumors, and the like. The company acquires a long-term, low-turnover base of owners who have reasonable expectations—and little reason to sell at every bump in the road.
• Management discipline — The best dividend-paying firms are compelled by the expectations of shareholders to continue making dividend payments, lest they risk alienating the kind of owners they’ve worked hard to attract. This imposes discipline on management’s decision making that is manifested in a conservative balance sheet, the efficient generation of cash, and a focus on core operations, all of which lead to higher total returns with less risk.

Morningstar Dividend Index Family

With the goal of helping investors, and the advisors who serve them, understand and access this part of the equity market, Morningstar has introduced a family of dividend indexes. Our key objective in designing these indexes was to generate a high-yield portfolio by selecting quality companies without compromising investment scalability.

We screen the stocks in the Morningstar US Market Index—a broad market index targeting 97% of the overall market capitalization— for dividend consistency and sustainability. All stocks that pass both screens form the Morningstar Dividend Composite Index, the top 100 stocks ranked by dividend yield form the Morningstar Dividend Leaders Index.

• Dividend Consistency — A company’s current dividend must be equal to or greater than the dividend paid five years ago. This ensures the company has a well-established and stable history of dividend payment.
• Dividend Sustainability — A company’s forward-looking earnings estimates must be greater than indicated dividend per share (i.e. dividend coverage ratio). This favors companies expected to have sufficient earnings to cover their dividends.
• Macro-consistent weighting —In order to retain the primary benefits of market cap weighting (e.g., low turnover and scalable investment capacity), we developed a weighting system we call “available dividends. We calculate available dividends for each stock by multiplying dividend per share by the number of shares actually available for purchase (the float).
• Broad diversification across companies — To ensure sufficient diversification in the resulting portfolio, we cap the weights of individual securities at 10% of the portfolio. Further, stocks weighing more than 5% each cannot collectively exceed 50% of the total portfolio.
• Rebalancing and reconstitution — Constituent shares and weights are rebalanced quarterly, and reconstitution—stocks added or deleted from the indexes—occurs once a year in June.
  

By design, the Morningstar Dividend Composite Index would serve as a good portfolio benchmark. Likewise, the Morningstar Dividend Leaders Index, with its shorter list of names, makes a better index fund. First Trust Advisors has launched an exchange-traded fund (Ticker: FDL) based on the Morningstar Dividend Leaders Index.

Dividends as an Investment Strategy

Using stocks with long, attractive dividend-paying records has a place in just about any portfolio—whether it is for someone just beginning to save or already in retirement. The most frequently used income-oriented strategies are:

• Core holding for income seekers — A high-yield portfolio has obvious advantages — more income for investors, a cushion against price declines, and a potential boost to total returns if share prices stagnate. Financial advisors can serve their clients well by increasing exposures to stocks that generate dividends, thus helping address income needs without forcing investment liquidation.
• Surrogate for large-cap value segment — Dividend-paying stocks are invariably value oriented, with the additional benefit of higher income than traditional value stocks. They can work in combination with other value investments to generate more income for the portfolio.
• Quality companies with low volatility — Dividends establish a firm intrinsic value for the stock, help reduce volatility, and act as a check on management’s capital-allocation decisions. The more consistent and sustainable a stock’s dividend payments, the more likely it will be superior performer in the end.

Investors and financial advisors looking for income, quality companies, and lower volatility, should consider the benefits dividend-paying stocks can have on a diversified, risk-appropriate portfolio. Morningstar’s new family of dividend indexes should make understanding, investing in, and monitoring this part of the equity markets easier, and lead to better outcomes for investors.