With interest rates continuing to hover around zero, investor interest in receiving income from dividend paying stocks has surged to levels not seen since in decades. That is until the Federal Reserve decided that it begin tapering its bond buying or quantitative easing programs this year. The announcement sent shivers down the spine of many dividend paying equities as investors worried that higher interest rates would clip the appeal of such stocks.
However, nothing could be further from the truth.
Dividends continue to hold appeal for many portfolios and could be one of the best ways to position yourself in a world of rising rates. For investors, adding a dose of dividends still makes a ton of sense.
The Key Is Rising Payouts
While there was some initial “freaking” when the Fed began its taper talk, dividend-focused equities could be one of the best places to continue putting new money in the new year. That’s because the combination of rising payouts and continued outperformance on the stock appreciation front makes them ideal rising interest rate fighters.
First, most dividend paying equities have a history of raising their pay-outs each year. What’s more important is that the annual growth in dividend raises often significantly outpaces inflation and higher interest rate changes. Over 885 companies increased their dividends by an average of 6% during the fourth quarter of 2013. Over the entire year, the amount of cash that stocks returned to their shareholders grew by over 10%. Both beating current inflation metrics and any rise in interest rates due to the taper tantrum. However, that 6% was only an average. For example, both retailer Home Depot (NYSE:HD) and insurance firm UnitedHealth (NYSE:UNH) increased their payouts by over 30% over the year.
And there is still room for companies to raise their payouts even more throughout 2014.
Payout ratios for dividend stocks are well below historic norms. According to S&P Dow Jones Indices, payouts by dividend firms are usually about 52% of free cash flows. However, today that metric only sits at a low 36%. That means firms still have plenty of room to raise their dividends throughout the year.
Then there is price appreciation returns to consider.
Morningstar (NASDAQ:MORN) data shows that dividend income has accounted for nearly 75% of annual U.S. stock market returns over the last century. That includes strong dividend stock performance during the 1970’s when interest rates surged to nearly 15%. More to the point, Morningstar’s data shows that dividend-paying stocks have returned around 11% per year. Beating non-payers by 3% since 1927.
Adding A Dose Of Dividends
While rising rates are a concern, investors can fight the effects by adding a dose of those stocks that continually grow their payouts over time. Given the recent freak-outs over the taper, several of these names are trading for slight discounts versus a few months ago.
A prime way to play them is through the Vanguard Dividend Appreciation ETF (NYSE:VIG). The fund tracks 146 different stocks that have a history of increasing dividends for at least ten consecutive years. That includes stalwarts like Abbott Laboratories (NYSE:ABT) and Coca-Cola (NYSE:KO). While the fund's current yield isn't super high- currently 2%- the idea is that over time it will increase based on rising payments from these firms. Similarly, WisdomTree US Dividend Growth (NASDAQ:DGRW) offers a chance to play a similar basket of stocks.
An equally juicy opportunity could be in those dividend payers located overseas. Already, international firms have a history of higher payouts than their U.S. twins. That’s represented by the higher yields of firms like British consumer products giant Unilever (NYSE:UL) or French oil major Total (NYSE:TOT). Yet, many of the same dividend growth elements apply to those firms as well. For those investors looking for larger current yield may want check out the PowerShares Intl Dividend Achievers (NYSE:PID). The fund continues the dividend growth trend by tracking the international version of VIG’s index. What you get is 58 different foreign firms that have raised their dividends over the last five years. Aside from diversification benefits, PID features a higher 2.59% dividend yield. Pairing it with VIG could be the best two-step in adding dividend growth to a portfolio.
The Bottom Line
With interest rates at near zero, investors have plunged head first into dividends as a way to get their income fix. So when the Fed decided to begin tapering, it sent shockwaves throughout the sector. However, those “shockwaves” could nothing more than pure non-sense. Rising dividend payments remain one of the best ways to fight higher interest rates and inflation over the long term. Funds like the iShares Select Dividend (NYSE:DVY) still have a place in your portfolio.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.