rd80 (99.11)

Stocks vs Bonds for income

May 22, 2009 – Comments (10)

A traditional model for investors is something like 100 minus your age = the percentage of the portfolio that should be in stocks with most of the remainder allocated to bonds.  Since I’m 50, this model would say half my portfolio should be in stocks with something like 40% in bonds and 10% in cash.  In today’s market, I think that allocation understates the inflation risk in bonds and doesn’t account for how far some solid, dividend paying stocks have fallen.

To illustrate, let’s project what could happen with a portfolio of blue chip, dividend paying stocks.  For this exercise, we’ll look at a portfolio equally weighted across Johnson and Johnson (JNJ), 3M (MMM), McDonald’s (MCD), Procter and Gamble (PG) and Emerson Electric (EMR).  These are all S&P Dividend Aristocrats, have good dividend yields and reasonable payout ratios.

 A portfolio spread evenly across these five stocks would have a current dividend yield of 3.65%.  For comparison the current yield on the 30-year Treasury is 4.34%, the 10-year is 3.39%.  You may ask, why would an investor take on the risk of stocks for income when they can nearly match the rate with a 10-year bond or beat it with a 30-year bond?  The answer - the coupon payment on those bonds is fixed, not so with the stocks.

I calculated the 5-year and 10-year compound average dividend growth rates for these five stocks.  To be conservative, I assumed they would continue growing dividends at 85% of the lower of the two growth rates.  McDonald’s CADGR was, in my opinion, unsustainable so I arbitrarily capped it at a 12% dividend growth rate.  The results for the five-stock portfolio are plotted below.  Photobucket isn't linking, so if the chart isn't here, the projected dividend yield on the initial investment by year is also listed.

2009  -  3.65%
2010  -  3.96%
2011  -  4.30%
2012  -  4.68%
2013  -  5.08%
2014  -  5.53%
2015  -  6.02%
2016  -  6.56%
2017  -  7.15%
2018  -  7.80%
2019  -  8.50%

A key point for income investors is that the stock price going forward isn’t particularly important as long as the company has the ability to continue paying and raising the dividend.  That said, the current market also offers significant upside potential for names like these as well.  If the stocks in this hypothetical portfolio were to trade back up to their 5-year average dividend yield, our investor would be looking at a 61.5% increase in the portfolio’s market value.  Of course, it’s also possible the stocks could fall in price.

Investors who don’t need the current income can get a double dose of compounding by reinvesting the dividends.

The characteristics I look for in income producing stocks are:
Good current yield
Track record of dividend hikes
Payout ratio below 50%
Growing earnings – some slack here during a recession, but not much

Warning signs are stocks with much higher dividend yield rates than their peers combined with a high payout ratio and earnings trouble.  Those are signs that the market is expecting the dividend to be cut.

Good places to start searching for stocks like these are the S&P 500 Dividend Aristocrats and Indxis Dividend Achievers.  S&P’s Dividend Aristocrats are members of the S&P 500 that have raised their dividend every year for at least 25 consecutive years.  There are currently 52 stocks on that list.  Indxis Dividend Achievers cover the broader market with 12 different lists.  Their Broad Dividend Achievers Index includes US companies that have increased their dividends for at least ten consecutive years and have at least $500,000 per day of average trading volume.  There are currently 283 stocks in that index.  Here on CAPS, fellow Fools sagitarius84 and Dividends4Life frequently post blogs analyzing dividend paying stocks.

I wouldn’t recommend completely abandoning bonds in a portfolio, but replacing part of a traditional portfolio’s bond allocation with select dividend paying stocks is worth considering at these depressed stock prices.

Disclosure, I’m long MCD and JNJ.