Scoop Up Dividends

The past year was a tough one for stocks that pay dividends. Through the first 11 months of 2009, non-dividend-paying stocks in Standard & Poor’s 500-stock index left dividend payers in the dust. What’s more, a record 78 companies in the index either reduced or suspended their dividends.

Nevertheless, the evidence is overwhelming that dividend-paying stocks are still your best long-term investment. Through the years, diversified portfolios of stocks that pay dividends have not only beaten those that don’t, but they have also handily outperformed the S&P 500.

Here’s an illustration of how dominant dividend payers have been over the long run. Starting with January 1, 1957, I sorted the index’s 500 firms by their dividend yield, going from highest to lowest. Then I recorded the return on the top 100 dividend yielders versus the bottom 100 and repeated this exercise for every year.

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The top dividend yielders are hands-down winners. If an investor had put $1,000 in a portfolio of the 100 highest-yielding stocks on January 1, 1957, by December 1, 2009, he would have accumulated more than $450,000 (assuming all dividends were reinvested). That’s a hefty annualized return of 12.5%, an average of almost 2.5 percentage points per year greater than the return on the S&P index. That same $1,000 invested in the 100 lowest-yielding stocks returned only 8.8% per year.

Depressed dividends. There’s no doubt that we have just experienced a dividend depression. For 2007, at the height of the bull market, the dividend stream -- total dividends paid on all U.S. stocks -- was $288 billion. For 2009 through November, the dividend stream had dropped to $216 billion -- the greatest decline in that measure since the end of World War II. Yet the entire decline in dividends can be attributed to the financial sector, which cut its total payouts by $79 billion over the past two years. (I’m including General Electric because GE’s dividend reduction was caused solely by the losses at GE Capital.) In other sectors of the economy -- energy, health care, technology, consumer discretionary, consumer staples, telecom -- dividends have actually risen over the past two years, even with the recession.

In early December, the S&P 500 yielded 2.0%. Although this is about one percentage point less than the interest rate on ten-year Treasury bonds, dividend payers have some decided advantages over Treasuries. For one thing, except in the midst of recessions, dividends tend to increase over time while coupons on government bonds remain constant. Two years ago, before the recession began, almost 300 companies, or 60% of those in the S&P index, raised their dividends. Even in the recession year of 2009, 148 firms in the S&P 500 increased their payouts.

A second advantage is that dividends have kept up with inflation. Standard Treasury bonds have no adjustment for inflation, and those that do, such as Treasury inflation-protected securities, offer real yields of just over 1%, about half the dividend yield on stocks.

Finally, dividends are tax-preferred compared with Treasury bonds. And they will probably remain so even if the tax rate on capital gains and dividends rises from the current maximum, 15%, to 20%, a proposal that’s being floated by the Obama administration.

Given that so many dividend-paying companies reduced or suspended their distributions during the recession, picking individual stocks can be risky. It’s safer to choose a diversified mutual fund or exchange-traded fund that includes an international component because dividend yields of overseas companies are higher than those of U.S. firms. In any case, don’t let the recent stumbles among dividend-paying stocks scare you away from a strategy with a proven long-term record.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.