Dividend-paying equities can be a great choice for long-term investors willing to forgo immediate returns in favour of substantial returns later. Once denigrated as the province of widows and orphans, dividend-paying stocks are being seen in a new light by investors who have weathered the highly volatile stock market of the past decade.

Turning to dividend-paying stocks during times of economic uncertainty is not a new concept. However, it’s one that seems especially relevant now, with the dividend yields of many stocks providing a relatively attractive alternative to the historically low yields delivered by bonds. While Canadian dividends are subject to preferential tax treatment, American dividend-paying stocks are also noteworthy given the current yield environment.

Compelling yields

Many stocks today offer compelling dividend yields relative to Treasuries—some say they provide the best advantage since the 1950s. In fact, as of September 30, 2010, the S&P 500 dividend yield is 2.03%, with the 3-month T-bill yielding 0.16%, 2-year T-notes yielding 0.42% and 5-year T-notes yielding 1.27%. What’s more, cash on corporate balance sheets is at unusually high levels. In other words, many companies are in a position to increase dividend payouts and respond to rising growth opportunities.

Companies with a long history of growing dividends have produced a favourable risk/reward profile over time, holding up better on the downside and producing better results on the upside. For example, the S&P 500 Dividend Aristocrats Index (companies in the S&P 500 Index that have increased dividend payout for at least 25 consecutive years) has provided higher returns with less risk than the S&P 500.

The benefits Dividend-paying stocks offer many potential benefits for investors:

  • A sign of quality: Consistent dividend growth can confirm a firm’s quality, as it shows the company’s ability to consistently increase cash flow over time. Many companies are currently in their best financial shape in decades; several companies have raised their dividends, some sharply. Coming out of the worst recession of our lives, we cannot help but believe these high-quality companies offer the best values in the financial spectrum.
  • A source of income: With bond yields at historic lows, stock dividend yields can be more compelling, especially for stocks with low price-to-earnings (P/E) ratios. Though it’s impossible to get more income with no risk, by choosing great companies, investors may get better returns with some risk.
  • A cushion from volatility: Though stocks have inherent risks and volatility, sometimes the risk/reward pendulum favours stocks. Compared to the overall market, dividend-paying stocks have a history of lower volatility, which means they can provide stability to an equity portfolio. It is now possible to buy a variety of stocks with current dividend yields that will likely grow over time, well above the risk-free rate of return. This has not been seen since the 1950s.
  • A growing option for retirement: All investors need investments that produce income. Income can also enhance a portfolio’s total return potential and help to temper volatility. And with a population of nearly 80 million baby boomers starting to retire in North America, this need for income will become even stronger. With longer life expectancies and the potential for rising inflation, income-seeking investors will need to make sure their money continues to grow. And dividend-paying stocks can help provide much-needed income.There are many reasons to take a closer look at dividend-paying stocks for investors with patient capital. One key factor to consider is that dividends, reinvested and compounded over time, have provided a significant contribution to total return.For example, with dividends reinvested, the S&P 500 produced a cumulative total return of 393.4% during the 20-year period from August 31, 1990 through August 31, 2010. Excluding dividends, price appreciation in the S&P 500 for the same time period was 225.3%—a difference of $16,810 on an original $10,000 investment.However, making the most of dividend opportunities requires stock selection expertise and active portfolio management.

    Hersh Cohen is chief investment officer and senior portfolio manager at ClearBridge Advisors, LLC, a wholly owned, independently managed subsidiary of Legg Mason, Inc.