It's no surprise that I'm a big proponent of diversification and having many different asset classes in my clients' portfolios. Diversification is useful for a reason: it gives you the chance to participate in the growth of different asset classes while hopefully minimizing the risk that a downturn in one sector will wreak havoc on your whole portfolio.
One common (and often quite important) part of an equity allocation is value stocks that pay dividends. They're not for everyone, but they can be a huge powerhouse to add to your stock allocation.
Skeptical? Consider this: the cheapest 100 stocks of the S&P 500 returned an average 13.8 percent per year between 1968 and 2012. The most expensive 100 stocks (the growth stocks) returned just 7.9 percent.
How is this possible? It all comes down to value.
The power of value stocks
You never know which asset classes are going to perform best in a given year, and large-cap value stocks are no exception. One asset manager that I recommend to certain clients has found that large-cap value stocks had the highest average annual returns between 1985 and 2004, but that they were the top performing asset class of the year just two times in that time period.
This demonstrates the power of dividend-paying stocks, which tend to fly under the radar and don't get as much attention from the media in comparison to high-flying story or cult-type stocks. These stocks tend to have less volatility and more consistency, and they're often cheaper (measured by their price-to-earnings ratio). Their value is additionally fueled by the regular and hopefully rising level of dividend payments that they offer. While those dividends might not seem like much in the moment, similarly to compound interest those regular payments can really add up over time.
The risks of value stocks
Of course, this doesn't mean that value stocks as an asset class will always be the "best" investment, or that you should forget about other asset classes. It's also important to know, you need to try to identify the right stocks within any sector and not just assume because it's in that particular sector, that it will be good.
Just like any asset class, dividend-paying value stocks have their weak points. For example, you'll often see a level of underperformance in bull markets. Where certain growth stocks can rise at extraordinary rates in the right environment, your "Old Faithful" value stocks typically will not! So, if you want to participate in that kind of growth and appreciation, you'll need to complement your dividend-paying value stocks with other asset classes. In other words, when it comes to dividend-paying value stocks -- or really any stock -- be patient and focus on the big picture.
I have found that it is not uncommon to see value stocks underperform in the short term during the beginning months of a rise in interest rates. One of the high dividend value equity managers I work with has stated they see their portfolio doing better in a period of rising yields once the fundamentals weigh in.
With the current economic environment, I believe that one of the sectors the market will be favorable to is dividend-paying value stocks -- especially if investors go the way of "flight to quality." These asset classes have seen more attention recently because of a search for more yield/dividends in the wake of low interest rates; if rates start going up at a measured pace (versus a rapid rise), I think we will continue to see money flow to more stable, high-quality sectors.
A great addition
As I mentioned, I don't advise making dividend-paying value stocks your only strategy. Diversification should always be on your mind when building a portfolio.
However, whatever your risk tolerance, dividend-paying stocks are certainly worth your attention. With excellent long-term returns and the stability of income-generating dividends, they can be a powerful addition to your portfolio.
Depending on your investable assets, I usually recommend an experienced asset manager versus a passive one, although you can also access these stocks through mutual funds or ETFs. Whatever you choose, these mundane Old Faithfuls demonstrate the benefits of stable growth, attractive pricing, and a long time horizon.
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