With all the headlines bonds have been making lately—and most aren't good—it's hardly surprising that many pros have been moving away from this nearly $36 trillion business. But that doesn't mean they haven't found a doppelganger of this once-steady form of income. After all, millions of Americans at or near retirement need enough steady income every few months to pay for the basics, finance vacations or even buy a few rounds of golf. The answer: stocks that act like bonds, only better.
SMART PICKSSome analysts recommend these dividend-paying stocks as good substitutes for bonds.
Paychex ( PAYX ) This payroll processor pays a steady dividend. With a yield about 3.9 percent, the company is "king of the mid-sized dividend players," says Sam Stewart, manager of the Wasatch Strategic Income Fund.
Wolverine Worldwide ( WWW ) The shoemaker behind Merrells and Hush Puppies has a 1.3 percent dividend yield. While that may not be eye-popping, the company should benefit as consumer confidence recover.
Gap ( GPS ) The retailer has shifted its focus to boosting profitability rather than just increasing sales, says Mark Freeman, co–chief investment officer of money-management firm Westwood Holding Group. San Francisco–based Gap has closed underperforming stores, freeing up cash.
Microchip Technology ( MCHP )
Most of Microchip's products are decidedly mundane stuff—chips for things such as garage doors and TV remotes. It's not sexy, but it means consistent sales, analysts say. The Chandler, Ariz.–based firm has little debt, and even during the downturn, it generated enough free cash to raise its dividend.
Sysco ( SYY ) The Houston-based food company used the last recession to go shopping, picking up rivals to boost its market share. The firm sports a solid balance sheet and has increased dividends each year for the past 20 years. "I can buy Sysco and not think about it," says Cliff Remily, co–portfolio manager of the $7.8 billion Thornburg Investment Income Builder fund.
Federated Investors ( FII ) The financial firm has $358 billion in assets under management and has paid a dividend every year since it went public in 1998. The Pittsburgh-based firm has often fattened that payout with a special dividend. While Federated's money-market business has struggled, the company has been able to boost market share as weaker rivals have bowed out.
PartnerRe ( PRE ) The Bermuda-based reinsurer, created after 1992's Hurricane Andrew, gets its revenue from a variety of sources. That diversity helps it remain stable even as the industry faces weak pricing, says Brian Angerame, comanager of the $768 million ClearBridge Mid-Cap Core fund. The stock has rebounded from its financial-crisis lows, but Angerame expects it to continue to rise once the industry regains some pricing power.
Source: Bloomberg
Indeed, dividend-paying stocks are fast becoming the "bonds" of the future, with more than $5 billion having gone into funds that invest in them since October, according to fund research firm Lipper. And it's not just the same old names, like IBM and Johnson & Johnson, crowding the portfolio lineups; pros say there are also some great finds among smaller and more obscure firms. Many of these smaller fries are generating plenty of cash and have long records of paying or boosting their dividends, with yields that stack up well against most government bonds. But perhaps the biggest draw is how dividend-paying firms, especially those with a history of raising payouts, can withstand inflation, which can diminish a bond's value fast. "With a bond, once you buy it, you are locked in at that rate. But with a stock, you could get a higher dividend," says Bernie Williams, a vice president at money-management firm USAA.
Investors are beginning to buy the argument. While most stock funds had more money go out the door than they attracted in 2010, equity income funds, most of which concentrate on dividends, pulled in a total of $7.8 billion, according to Lipper. While many of those funds focus on the blue chip names, many smaller companies, from food distributor Sysco to asset manager Federated Investors, have been paying dividends for decades. In the sweet spot are smaller firms with a history of paying dividends and the wherewithal to boost the payouts in the future, says Kimberly Scott, manager of the $650 million Ivy Mid-Cap Growth fund.
Some analysts expect dividend payouts to continue to increase this year, as pressure increases for firms sitting on lots of cash to do something with it. Yes, that means Cisco might use some of its nearly $40 billion in cash and short-term investments to pay a dividend, but smaller firms, such as retailer Kohl's, are also looking at instituting a dividend. More than half of the firms in the Russell 2000 small-cap index already pay dividends, bucking the common perception that smaller companies just plow all their cash back into their businesses to grow. "Dividends in the small-cap world are really a well-kept secret," says Paul Magnuson, comanager of the NFJ Small-Cap Value and Mid-Cap Value funds.
Companies that pay dividends also tend to be less volatile. The payout signals that the firm's management believes their profits aren't going to disappear if the economy turns south. That puts these companies in an "elite class," Magnuson says. In fact, over the past 20 years small-cap firms with a dividend outpaced their non-dividend-paying peers by an average of 14 percent a year. In contrast, large firms that paid dividends beat their non-dividend-paying peers by only 5.3 percent a year, according to financial research firm Ned Davis Research.
While bond investors might be tempted to buy stocks with the highest dividend yields, strategists recommend focusing instead on dividend growth potential and companies that are not yet paying out large amounts of their profits. Lofty payouts and yields also could be a sign of struggling companies.
To be sure, all stocks, even dividend-paying ones, can lose value. Small and midsize stocks also have been among the best market performers over the past two years. But the dividend payers in these groups have cheaper valuations than those not paying dividends, according to Ned Davis Research. Dividends from smaller firms are also slightly lower, on average, than those of larger companies. Mid- and large-size companies, for example, pay an average dividend of 1.4 percent, compared with 1.8 percent for large companies, according to financial firm Russell Investments. But their average dividend growth rates are similar, with midsize and large companies alike increasing payouts by, on average, about 5 percent annually.
Considering that rising interest rates could swamp the bond market (bond prices move in the opposite direction of interest rates) and that the broad stock market is not cheap, strategists say getting income from different types of investments is key. "You need all parts of your portfolio producing income," says Christopher Wolfe, chief investment officer for Merrill Lynch's private banking and investment group.
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