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Ask The Expert: How Can 'Dividend Aristocrat' Stocks Help You Beat The Market?

Monday, February 18, 2013 10:00 AM

Editor's note: Each week, one of our investing experts answers a reader's question in a Q&A column at our sister site, InvestingAnswers.com. It's all part of our mission to help consumers build and protect their wealth through education. This week's question will be answered by Investment Analyst David Sterman...

Since the financial crisis of 2008, many investors have lost interest in growth stocks and prefer to focus on stocks capable of generating solid dividends. Today's question looks at an investment strategy that focuses on the very best dividend-paying stocks.

Question: I've been hearing a lot of good things about "dividend aristocrats." What are they, and should I be investing in them?
--Frankie, Tucumcari, New Mexico

Answer: Frankie, the name alone should tell you that these are a special group of companies. Standard & Poor's (S&P) did an exhaustive amount of research, seeking companies that manage to raise their dividends year in and year out -- even when the U.S economy slows. They found that these companies are likely to keep boosting their dividends at a steady pace, well into the future, rain or shine.

To be a "dividend aristocrat," a company must be in the S&P 500, have a market value of at least $3 billion and must have boosted its dividend -- by a little or a lot -- for 25 years straight. In just the past year, Chevron (NYSE: CVX), Cardinal Health (NYSE: CAH) and Pentair (NYSE: PNR) have been welcomed into the club. On the flip side, the financial crisis of 2008 caused many longstanding members of the club -- most notably the big banks -- to drop off as dividends were slashed to preserve cash.

Of the 500 companies in the index, 42 (or 8%) make the grade. The average dividend yield of these aristocrats is 2.8%, compared to the 1.8% yield offered by the other 458 companies in the S&P 500.

S&P found that these companies offer up a unique twist. Not only do they generate steadily rising income streams, but they also tend to see their share prices rise in value at a respectable clip. In fact, S&P's researchers studied data from the past 90 years and found that dividend payments accounted for about one-third of the wealth that these stocks have generated, with the other two-thirds of the investment return captured by rising share prices.

A basket of these stocks has delivered a total return (dividends plus stock price gains) of 6.3% annually during the past five years, which is three times the gains posted by the broader S&P 500. In fact, the S&P 500 Dividend Aristocrats index has outperformed the S&P 500 index during three-, five-, 10- and 20-year periods on a total return basis.

Offense And Defense
Part of the charm of owning stocks that sport rising dividend yields is their broad-based appeal in bull or bear markets. In a bull market, these stocks tend to rise in tandem with the broader averages. And when the market slumps, investors are inclined to sell other stocks and hang on to their dividend-paying stocks as buy-and-hold investments. That means they're less subject to the wild price swings that other stocks have generated in recent years.

And whereas other dividend-focused strategies tend to tie investments to a particular industry such as utilities, real estate (REITs) or energy master limited partnerships (MLPs), the dividend aristocrats are represented by many industries. This removes the risk of your portfolio being tied to just a narrow slice of the market.

So should you invest in aristocrat stocks? The answer is a qualified yes. These companies are surely tried-and-true winners, but they've also become especially popular in recent years as the relative yields of fixed income investments like bonds and CDs have slumped toward zero.

Eventually, those types of investments will begin to offer better yields, which will draw some attention away from dividend-paying stocks. In effect, these aristocrats offer great long-term opportunity but, as with many stocks, might slump in value in the short term. So the answer to your question really depends on how long you plan to own them.

Action to Take --> The stocks that qualify as dividend aristocrats typically don't offer the most robust dividend yields. Indeed, many stocks such as AT&T (NYSE: T) and Duke Energy (NYSE: DUK) offer yields in the 4% to 6% range -- roughly twice the yield of the typical aristocrat. Yet unlike the higher yielders that possess more limited growth prospects and may boost their dividends only modestly, the dividend aristocrats appear to be in a very good position to steadily boost their dividends at a faster pace. Own them now and you may be stunned to see what kinds of dividends they are generating a decade or two in the future.

This article originally appeared on InvestingAnswers.com:
Ask The Expert: How Can 'Dividend Aristocrat' Stocks Help You Beat The Market?

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of T in one or more of its “real money” portfolios.