Friday, October 01, 2010

Recovering with Dividend Income Investing

Morningstar Dividend Investor
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Don't lose another decade! Change your approach to stocks by focusing on income. By Josh Peters, CFA | Editor, Morningstar DividendInvestor

You don't need me to say that making money in this market is hard. Merely hanging on to what we already have is hard enough. Some have termed the last 10 years a "lost decade" for stocks, as the typical American investor has been rewarded with temporary gains at best and permanent losses at worst. The ongoing volatility, uncertainties and disappointments have kept millions of investors from reaching their goals.

Yet I am not about to give up. Having worked hard and saved, I'm determined to hang on to the fruits of my labor and increase its value over time. Like you, I have real-world financial obligations to meet over the next couple of decades. Moreover, investing is my chosen profession, and I pursue its opportunities and rewards with passion. But no longer do I fight this battle on Wall Street's terms.

Over five years ago, I charted a new course. I focus on income instead of capital gains. I approach stocks as a potential owner and partner in a business, rather than a trader. And I insist that any business I partner with must treat me fairly. The factor common to these three goals is simple: dividends. Not just any dividends, but large, reliable and growing streams of cash that I never need to give back.

Where did we go wrong?

Many explanations are being offered as to why stocks have had such a poor run so far this century, and most of have at least a bit of truth. Stocks were incredibly overvalued in 1999, and a series of economic and financial calamities certainly didn't help. But a share of stock is still a claim on the earnings of a business. If we want to know where things went wrong, I say, "follow the money."

The sad fact is that most American corporations no longer recognize or treat shareholders as true owners. Even as the economy struggles to climb out of the worst recession in over 70 years, profits are soaring. Yet the bulk of these earnings, as in the decade just past, aren't finding their way to investors. Instead, these rivers of cash are diverted toward empire-building acquisitions, dubious share repurchases, and obscene executive pay packets.

This has led to an environment where no matter how interest rates seem to go, stocks still can't compete. Total profits for the companies that make up the Standard & Poor's 500 index could top $900 billion in the upcoming year, yet their dividend payments are running at only $211 billion--less than 25 cents on the dollar! The average stock in this group yields only 2%, half of the historic average of 4%. Some of our best-known, best-loved companies like Apple AAPL and Google GOOG get away with paying nothing at all. With virtually no say in how large companies are managed, it's hardly a surprise that investors are voting with their feet.

The worst part of this story is that our corporate leaders have learned nothing from this experience. Pitiful yields require investors to rely on capital gains for the bulk of their returns, but why should stock prices go up when their dividends remain tiny? Looks like a formula for more of the same old stagnation.

At the same time, interest rates are very low by any historical standard. By now millions of former shareholders have shifted into bonds, seeking the same thing they ought to get from stocks--a better income and more reliable returns. But when bond yields are very low, the rewards will likely be small and risks loom large. Inflation--not that we've seen much of it lately--is not dead, but could come roaring back to clobber the bondholder's real wealth.

By now you may be asking, what could possibly be left?

The fork in the road.

When I set out to seek better results, I had to let go of the idea that a stock is a piece of paper to be traded back and forth. Frankly, as manager of Morningstar DividendInvestor's two model portfolios, I engage in relatively few buys and sells. Instead, I've taken on the mantle of the great capitalists of old: Those who sought out good businesses, invested their money only on attractive terms, demanded a fair share of the profits, and let their capital do the work.

This approach will not work with just any old stock. Above all, such a strategy requires a large dividend yield--no less than 3% these days, in my opinion, and preferably between 4% and 7%--to provide a reasonable prospect of success. This alone narrows the universe of potential investments down from thousands to a few hundred at best--but I strongly believe this narrow field, and my own narrow-minded approach, presents better-than-average prospects.

The truth is that dividends are more than just pocket change, more even than a basis for a comfortable retirement. Dividends are the sole and essential link between investors and the businesses they own. Where you find large, reliable and growing dividends, you're probably looking at an enterprise that is consistently profitable, relatively unburdened by debt, and whose management runs against the tide to treat shareholders like actual partners. Where you find small, irregular or unsustainable dividends--or no dividends at all--you may be rolling the dice.

From its first issue, Morningstar DividendInvestor has been completely devoted to the pursuit of the best businesses a conservative, income-minded shareholder could want to hold. In the years since January 2005, we have compiled a record of superior performance--not by daytrading or swinging for the fences, but by clinging to our daily pursuit of sound, rewarding companies.

Day by day and month by month, I comb through the market for such extraordinary businesses. I put each and every candidate through a rigorous set of tests focused on their dividends. Those that pass become part of our model portfolios--each of which demonstrates returns with real-money transactions, not paper-based claims.

Investment success in the decade to come will not come easy, or by accident. Having lost the last decade was a dreadful shame. Losing another is simply not an acceptable outcome. To stand out, I believe an investor will need unique perspectives on the markets, an unusual amount of discipline, a willingness to shed Wall Street's hot-money mentality ... and above all, an insistence on being rewarded as a stock's rightful owner through attractive and rising cash dividend payments.

These are what I, in the pages, website and e-mails of Dividend Investor, am determined to provide.

My "pitch" holds no mystery: If DividendInvestor sounds like a service that might help you meet your family's financial goals, give us a try. And with our money back guarantee, there's absolutely no risk.

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