3 Factors Make Equity Income a Viable Strategy

There’s no doubt the past few years have been challenging for most investors. At the same time, three factors have created an opportunity for those who are looking for investments that generate cash.

A combination of retiring Baby Boomers, more cash than usual on corporate balance sheets and a look at the total return for the S&P 500 over various time periods make an equity income strategy (or dividend-paying stocks) an attractive option for many of my clients.

Baby Boomers

The first of the country’s 76 million baby boomers are turning 65. For most boomers the transition from the workplace to retirement is still ahead, but the changes they make to their investment strategies will have a huge impact on the financial markets. Sources indicate that baby boomers’ assets now account for nearly 80 percent of all financial assets and are responsible for potentially half of all discretionary spending power.

Baby boomers are going to need cash-generating investments to fund their retirement. In today’s low interest rate environment, focusing on stocks that pay dividends is one way to do that.

Cash on balance sheets

Companies accumulated a huge amount of cash during the market collapse from 2007 to early 2009, when they were doing whatever they could to cut costs and raise cash. At the same time, corporations were reducing the excessive debt that had accumulated since the early 2000s.

The cost-cutting resulted in significantly improved corporate margins, leaving companies with more cash—just under $1 trillion by mid 2010, according to some reports—on their balance sheets. While cash is a good thing for corporations to have on hand, it’s not the most productive asset to hold when interest rates are as low as they are now.

One reason is that investors consider the return on equity (ROE) a company is able to generate when they evaluate a potential investment. Part of the calculation of ROE involves the asset turnover ratio, which is determined by taking sales and dividing it by assets. For most companies, the higher the asset turnover ratio, the better. Cash on hand can result in a lower ratio, which in turn detracts from overall ROE.

Many companies that want to deploy excess cash without making long-term commitments such as expanding property or increasing their workforce decide to pay dividends to stockholders.

Total return for S&P 500

Dividends likely offered investors little solace during the market decline from 2007 through September 2009. But a look at the S&P 500 over a longer period of time shows the bigger picture. Dating back to the 1950s, there is strong evidence the stocks that had the highest dividend yield (annual dividend divided by stock price) provided a substantially higher total return than the ones that had the lowest dividend yields, according to finance professor Jeremy Siegel in his column, “The Future for Investors.”

For the 20-year period from September 1990 through September 2010, dividends have accounted for more than 40 percent of the total return for the S&P 500, according to Facset. The dividend element of stocks is often overlooked, but I think it’s a vital part of a successful investment strategy.

All three of these factors—retiring baby boomers, excess corporate cash and a long-term look at the S&P 500—make equity income a strategy worth considering. A well-diversified, globally invested portfolio with a tilt toward dividend-paying stocks has the potential to reward investors for years to come.