By Chris Leavy
Investors have been warming to dividend stock investing. It's hardly a surprise. Interest rates are at record lows, and with more Americans entering retirement-and spending more time there than generations before-income is a hot, if not elusive, commodity.

In January, while U.S. equity funds suffered their ninth consecutive month of outflows, equity income funds attracted $4.3 billion in investor assets, Lipper data reveal. These flows indicate growing retail interest in equities as an income source. Is that a good or bad omen? Experienced advisors recognize elevated mutual fund flows as a contrarian signal, and might wonder if the dividend trade is overheating.

Are we in a dividend bubble? Our answer: Not nearly.

Room To Grow

The argument for keeping focus on dividend investing centers on the tremendous potential for continued growth in three key areas:

Investor assets.  Investors are catching on to the idea of generating equity income in a world starved for yield. Yet, this trend still has room to grow.

Equity dividend investing is not a crowded trade. In fact, investor flows into taxable fixed-income versus equity-income funds reveal that taxable fixed income is more crowded. Lipper Fund Flows data indicate that taxable bond funds captured nearly $128 billion in investor assets in 2011, whereas Lipper Equity Income funds saw only $22.4 billion in inflows.

Valuations. Investor behavior is one thing, but the question of valuation is perhaps even more telling. Equities with low or no dividend yield may be inexpensive relative to the broader stock market. However, high-dividend-yielding equities do not appear overvalued.

Globally, in absolute terms, the top two quintiles for dividend-yielding stocks are reasonably priced at 12 to 14 times forward earnings. Despite the market rally, these valuations remain compelling, particularly versus fixed income. Such numbers blunt any argument that we are in a dividend stock bubble.


Dividends. Looking forward, we expect dividends will continue growing for two reasons-healthy corporate earnings and an increase in the payout ratio of corporate profits.

First, dividends tend to follow earnings growth. In recent years, corporate earnings growth has been fueled by a recovery in profit margins and increasing revenues. While corporate earnings growth is moderating due to slowing margin growth, we believe revenues will continue to grow. Over the long-term, S&P 500 core revenue growth has been approximately 6%, tracking global nominal GDP growth of 6% over time. Even if profit margins run out of room to expand, operating earnings should still grow in line with revenues, enabling dividends to grow in the mid-single digit range.

Second, we believe payout ratios are likely to rise. The current 28% payout ratio of U.S. companies is about half the market's historic average. Although payouts may not return to their historic levels, we expect ratios to rise as company managements become more confident in their much-improved balance sheets and financial positions. If the payout ratio rises as we expect, dividend growth would exceed earnings growth.

Besting Bonds

Dividend stocks also appear quite attractive versus traditional income sources. Companies are generating cash today at historic highs relative to U.S. Treasury yields, suggesting equities are inexpensive and extremely appealing compared with bonds. In fact, the free cash flow yield (free cash flow as a percent of a stock's price) is today between 6% and 6.5%-400 to 450 basis points higher than the current 2% yield on Treasuries. This is an unusual scenario seen only rarely over the past 50 years.

More important, in our view, is the fact that free cash flow can grow, while a bond coupon cannot.

Many investors appreciate the assured income stream that a bond's coupon provides. The downside, however, is that a coupon is not going to grow over time. Equities, in addition to offering a dividend yield that rivals the yield of government bonds today, have historically provided long-term dividend growth allowing investors, retirees in particular, to keep pace with or even outrun inflation.

And because stock prices tend to follow dividends over the long term, the investor's capital can grow as income grows. Without the dividend and capital growth components, investors face a very high likelihood of outliving their nest egg, particularly in a world where populations are living longer. In the U.S., for example, studies show that once a couple reaches age 65, there is a 50% chance that at least one of the two will reach age 92. Assuming retirement at 65, that couple's nest egg will need to provide for 27 years. The portfolio must stay ahead of inflation-and equities offer the potential for that type of growth.

Even moderate inflation can significantly erode an investors' purchasing power. At a modest annual inflation rate of 3%, income of $100,000 dwindles to $47,761 in 25 years. At a 5% rate, investors are near the poverty line in their 25th year of retirement.

Long life should be a blessing, not a burden. Dividend equities, in our view, can help investors protect their livelihood.


Dividends Pay In More Ways Than One

No investment is without risk, but strong corporate fundamentals today underpin the argument for an equity dividend strategy. Companies that pay dividends typically have better business models, stronger balance sheets and greater confidence in their secular growth capabilities. While there is no guarantee that dividend-paying companies will continue to pay dividends, all of those characteristics historically have helped these companies' stocks to outperform in difficult and volatile times, such as now.

Analyzing the portfolio contribution of dividend-paying equities reveals that companies with high dividend yields and high dividend growth rates outperform with less risk than non-dividend-paying companies over the long term. Companies with high and growing income streams provide a level of safety and stability not offered by non-dividend-paying companies, because growing income streams can help smooth short-term volatility and provide the potential for more consistent total returns.

For all these reasons, we think dividend-paying equities occupy a "sweet spot" between investment-grade fixed income and equities in general-making them a great way for retirees and risk-aware investors to commit assets in today's nervous stock market.

The Bottom Line

More and more people are entering retirement, living longer and starving for income (and income growth) at a time when traditional sources cannot provide it. The equity income play may not be in its first inning, but nor is it near the ninth. Dividend-paying stocks allow investors to achieve above-average income today and long-term growth for tomorrow, and are still very reasonably priced in the current market.

It's a new world of investing. To adapt and be successful today, advisors and investors must acknowledge that old expectations about asset performance have been upended. Bonds are no longer the go-to source for income. Many stocks are offering higher yields than the same company's bonds. Fixed income is not the be all and end all for retirees and other income-oriented investors.

The bottom line: Investors with an income crisis are well-served by diversifying their income stream to include dividend-paying equities.

Chris Leavy, managing director, is chief investment officer of U.S. fundamental equity at BlackRock. Leavy holds a B.A. in economics from Trinity University and an M.B.A. from Columbia Business School.