The Enduring Qualities of Dividends - Ameriprise Financial

The Enduring Qualities of Dividends

Lyle B. Schonberger Vice President, Investment Research Group

November 26, 2014

Enduring: defined as "lasting over a period of time; durable."

Attractive Returns with Lower Risk

Over time, dividend-paying stocks have outperformed non-dividend stocks, and this achievement has come with lower risk (volatility). Past performance does not guarantee future performance. However, we offer some compelling evidence that emphasizing dividend-paying investments and dividend reinvestment as a component of a broader investment strategy has withstood the test of time. This includes environments with rising interest rates and ever-changing income tax rates, as well as periods of time with unusual market volatility (e.g., the U.S. "great recession" of December 2007 ? June 2009).

The 12 Key Principles

In May 2013, we introduced The 12 Key Principles to Long-term Wealth Generation Through Disciplined Dividend Growth Investing. This update features updated market data. The basic premise of the report remains the same.

Consider the Risks

Investing in equities involves risk and the possibility of material investment losses, especially over relatively short time horizons. We strongly recommend implementing the strategies and concepts highlighted in this report as part of a broader long-term asset allocation and investment diversification strategy. We urge investors to work with a financial advisor and also a tax advisor ? starting early with professional advice could potentially mitigate risks and losses down the road.

Dividend Yield and Relative Performance 1957 - 2013

Dividend

Yield

Total

Quintile Highest High Mid Low

Return 12.82% 12.57% 9.77% 9.20%

Beta 0.94 0.82 0.92 1.07

Each stock in S&P 500 is ranked from highest to lowest by dividendyield on December 31st of every year and placed into "quintiles," baskets of 100 stocks in each basket. The stocks inthe quintiles are weightedby their market capitalization. The dividendyield is definedas each stock's annual dividends per share divided by its stock price as of December 31st of that year.

Beta is a statistical measure of risk (volatility). A beta higher than 1 implies more risk (volatility) than the benchmark; a beta less than 1 implies less risk (volatility) than the benchmark.

Lowest S&P 500

9.46% 10.69%

1.23 1.00

Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

Source: Siegel, Jeremy, Future for Investors (2005) , With Updates to 2013; Ameriprise Financial Services, Inc. Copyright Jeremy J. Siegel

PLEASE NOTE: FOR IMPORTANT DISCLOSURES, INCLUDING POTENTIAL CONFLICTS OF INTEREST, PLEASE SEE THE LAST TWO PAGES OF THIS PUBLICATION.

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The Enduring Qualities of Dividends

November 26, 2014

THE ENDURING QUALITIES OF DIVIDENDS

Challenge: Name an investment strategy which

? Offers potential for growth and compounded income ? Hedges against inflation ? Is transparent ? Receives favorable tax treatment (under current law) ? And denotes quality and strength

Further, as demonstrated in the next chart from Ibbotson, a leading authority on asset allocation and long-term market returns, the difference between capital appreciation without, and with, dividends reinvested, is enormous. We note this is an exceptionally long time horizon (86 years) versus a "normal" real-life investment time horizon. Nonetheless, the concept is valid, and later in this report we build out some examples based on a more realistic 20-year time horizon.

Value of $1 Invested in Large Company Stocks 1926 - 2013

Answer: Stocks paying growing dividends

10.1% CAGR $4,677

"Enduring" is defined as lasting over a period of time; durable. And this is precisely how we view the fundamental qualities of dividends and dividend-paying companies.

From a macro perspective, dividend income is growing faster and more steadily as a percentage of personal income than other forms of personal income. According to research from Aye Soe at S&P Dow Jones Indices (based on Bureau of Economic Analysis data), dividend income in 2012 was 5.64% of per capita personal income in the U.S., up from 4.39% in the prior ten years and 3.51% in the prior 20 years. Interest income still outranks dividend income as a percentage of personal income, however the trend is down, partially due to the low level of current interest rates. In 2012, interest was 7.39% compared to 13.51% in 1992. The total value of dividend income was $757 billion in 2012, up from $188 billion in 1992 (growth of over 300%). Interest income grew less than 100% during that same period.

We believe an investment strategy emphasizing dividends and dividend growth can be effective in nearly all market cycles and business environments: inflationary, expansionary, contracting, and even sideways. Over the long-term, dividends have been a major component of stock market returns. According to S&P Dow Jones Indices, from 1926 ? 2013 dividends accounted for 34% of the long-term total return of the S&P 500 Index. During some decades, such as the relatively high inflationary periods of the 1940s and 1970s, dividends amounted to 50%+ of long-term total returns.

60%

Dividend Income as a Percentage of Monthly Total

53% Return of the S&P 500 Index: 1926 - June 2014

50% 50%

40%

39%

30%

28%

20%

10%

34% 26%

14%

0% 1940s

1950s

1960s

1970s

1980s

1990s 1926 to June 2014

Source: S&P Dow Jones Indices, "Dividend Investing and a Look Inside the S&P Dow Jones Dividend Indices," March 2013 (with data updated through June 2014) Past performance is not a guarantee of future performance. It is not possible to invest directly in an index.

5.8% CAGR $145

Capital Appreciation Without Dividend Reinvestment

Total Return with Reinvested Dividends

Large company stocks represented by the S&P 500 Index. It is not possible to invest directly in an index. Past returns are not a guarantee or indicator of future returns. Does not take into consideration taxes or fees.

CAGR = compound annual growth rate

Source: Ibbotson SBBI 2014 Class Yearbook; Ameriprise Financial Services, Inc.

Setting the Stage: Defining the Enduring Qualities of

Dividends

We summarize our observations and thoughts as follows:

? Unlike many income statement lines such as sales, general, administrative and other expenses, taxes, and to a lesser extent, cost of goods sold, dividends are an exceptionally transparent measure of value and financial health for a company. This holds true because dividends cannot succumb to over or understatement by accounting vagaries, or other purposefully deceptive tactics

o Many business decisions and expenditures can be timed as needed ? accelerated, delayed, or otherwise adjusted ? to achieve a pre-determined earnings target

o Current accounting rules allow for numerous exceptions and adjustments, which can also cloud the true picture of a company's financial health and profitability

o Dividends are fully transparent ? you will know when it was paid, how much was paid, and whether the payment was the same as the prior payment, higher, or lower. You will also clearly know if it was NOT paid or if it was delayed, and if necessary, you can adjust your portfolio accordingly

? Dividends can imply a higher value, since over time dividend-paying stocks tend to outperform those that do not pay a dividend (or that have cut or eliminated their dividend)

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The Enduring Qualities of Dividends

November 26, 2014

? Dividends have historically grown faster than the U.S. inflation rate and can be a significant contributor to an investment's total return

o A disciplined dividend reinvestment strategy reduces the payback period for an equity investment, and this positive impact can be magnified when combined with a dividend growth investing strategy

? Dividends mitigate volatility. This is demonstrated by historically lower beta and standard deviation (beta is a common statistical measure of historical price volatility of a stock versus an appropriate benchmark; standard deviation measures the variability of returns over time for a stock or index)

? Dividends provide a measure of downside market protection, especially when coupled with a dividend reinvestment strategy, as investors tend to focus on the long-term when dividends are paid and accumulated over time

? Dividends indicate financial strength and greater management discipline, as companies that pay dividends tend to be well-managed in order to meet the board's dividend policy and avoid dividend cuts

? Demographic shifts across the U.S. and many other developed-market countries reflect a gradually aging population, and appear to be a long-term macro condition; this dictates that collective retiree investment income needs may continue to grow for decades to come

Furthermore, dividends can increase over time as the invested company's profit grows. The combined result provides a compounding effect that can create wealth regardless of stock market performance.

Finally, a stable cash income (yield) can provide a cushion in down markets.

A look at the performance of two representative dividendoriented indices demonstrates the positive impact that dividends have had on performance since the beginning of the most recent secular bear market in 2000.

? The Dow Jones U.S. Select Dividend Index includes the 100 highest yielding stocks in the broad-based, Dow Jones U.S. Total Stock Market Index, with a non-negative dividend growth rate over the last five years, and a payout ratio of less than or equal to 60%.

? The S&P 500 Dividend Aristocrats index contains companies in the S&P 500 that have not only paid, but have increased their dividends for 25 consecutive years.

Both Indices outperformed the S&P 500 Index by a wide margin during the secular bear market. A $100,000 investment made at the start of 2000 through the end of December 2013 would have grown to $358,175 and $366,056, if invested in the Dow Jones U.S. Select Dividend and the Dividend Aristocrats indices, respectively. The same amount invested in the S&P 500 Index would have gained considerably less, reaching $125,492 over the same 13-year period (and notably, when measured at the end of 2012, would have actually amounted to a loss of $3,170). These figures exclude the impact of taxes and fees. If taxes and fees had been included, results would have been lower.

The 13-year Secular Bear Market: 2000 to 2012

We discussed at length the secular bear market of 2000 ? 2010 in a prior dividend growth investing white paper. As time marched on, we now believe the secular bear market persisted through 2012. In reviewing the 2013 ? 2014 market climate with our Senior Market Strategist, Marc Zabicki, CFA, we believe the U.S. equity markets may have exited secular bear territory and now resemble the early stages of a long-term secular bull market. Some of this thought process is gleaned simply from price charts where, throughout the 2013 ? 2014 timeframe the S&P 500 Index set multiple consecutive record highs. Part of the thought process is also based on fundamentals ? the U.S. economy is improving; consumer and corporate balance sheets are in arguably the best shape ever due to deleveraging (debt reduction); the housing market appears to be on a sustainable upward trajectory; and the Fed remains accommodative (although rates will rise at some point). Time will tell if the secular trend has shifted. However, we wish to revisit briefly our secular bear discussion, because the importance of dividends is magnified during secular bear markets for multiple reasons:

Dividends create wealth by providing a cash return to the shareholder on an ongoing basis. This cash return can be used to purchase additional shares, which allows the investor to build equity and potentially increase future dividend distributions.

$400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000

$50,000 $0

Value of $100,000 Investment 12/31/1999 - 12/31/2013

S&P 500 DJ US Select Dividend

S&P Dividend Aristocrats Barclays US Aggregate Bond

Returns shown are price returns for the equity indices and total returns for the bond index. Source: Bloomberg; Ameriprise Financial Services, Inc.

Past performance is not an indicator of future performance. Data excludes transaction costs and taxes. Results would have been lower if transaction costs and taxes had been included. It is not possible to invest directly in an index.

Despite the solid relative performance, both indices have inherent weaknesses that we believe can be overcome by a more actively managed portfolio solution. We have two main concerns with the Dividend Aristocrats. First, it is limited to large, very established companies, providing no exposure to smaller, faster growing, dividend payers. Second, there is no

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The Enduring Qualities of Dividends

November 26, 2014

Peak-Saver Population Declines as Boomers Retire ...

% aged 35-54 35% 30% 25%

% aged 65+

... Ratio of Peak Savers to Retirees Falls to Record Lows

4.00 3.50 3.00 2.50

20%

2.00

15%

1.50

10%

1.00

5%

0.50

0%

0.00

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045

Historical data from 1945 through 2011, forecasts for 2012 through 2045. Source: United States Census Bureau, Morningstar analysis

minimum yield requirement. Therefore, even an overvalued company with a relatively low yield can be maintained in the portfolio, as long as the dividend was increased for 25 consecutive years. The Dow Jones U.S. Select Dividend Index is a broader based index than the Aristocrats, and is focused on the highest yielding stocks, but at times can lack adequate sector diversification. Furthermore, there is no requirement for dividend growth. An actively managed portfolio can seek to overcome both of these issues.

The Demographic Trend Is Your Friend

We often hear market technicians say "the trend is your friend" when they have identified a particularly compelling buy or sell opportunity based on an historical price chart or other indicators. However, more to our point here, from a long-term fundamental investment perspective, we believe the demographic trend is your friend when it comes to dividend investing. While stocks usually do not move higher in a straight line (just consider the 13 years during the most recent secular bear market to experience this), we believe there are compelling long-term tailwinds at hand which could provide a terrific environment for dividend-paying equities over the coming decades. While we acknowledge that most investors do not look out decades for a typical investment portfolio, it is important to keep in mind that there are some very long-term aspects to investment portfolios ? 401K plans, IRAs, and college savings plans (when started at birth) do indeed have multi-decade time horizons. Even saving for a vacation home or a dream tour of the world can take many, many years.

According to Morningstar, a couple of big-picture dynamics are driving this trend ? the U.S. population is aging; the peaksaver population is declining; and the number of retirees is expanding (source: Morningstar Institutional Equity Research: Demographics and High-Dividend Equities; Josh Peters, CFA, Director of Equity-Income Strategy).

As demonstrated in the charts above, we can clearly see the current environment and the long-term projections regarding the aging U.S. population. The 65-plus population is continuing to expand as baby-boomers age. This in turn

reduces the ratio of peak-savers to retirees. Couple this with the fact that the number of people who receive pensions is on the decline, and barring a major legislative and structural overhaul, the risk that Social Security benefits for seniors may eventually need to be reduced, it appears inevitable that retirees will need to rely ever-more on their own savings (for example, qualified plans such as IRAs and 401-K plans). We believe this trend sets up an environment where savers (investors) will increasingly demand dividend-paying stocks in defensive sectors (Consumer, Health Care, and Utilities, for example), along with relatively higher dividend yields. This could help set up a long-term bull market environment in these types of stocks, in our view.

What About Rising Interest Rates?

Interest rates, already in a long-term downtrend since about 1980, have remained close to multi-decade lows since 2008, due to aggressive FOMC intervention and ongoing massive quantitative easing during and following the "great recession" of December 2007 ? June 2009. The point of this paper is not to argue for or against the historically unprecedented monetary and fiscal policy actions of the prior and current administrations. However, now that interest rates have been scraping along the bottom for several years, coupled with our belief that the U.S. economy is showing slow but steady improvement, it is our belief that interest rates have the propensity to rise from here.

So how do rising rates impact stocks? Conventional wisdom dictates that rising rates have the potential to knock down equity valuations, because investors will sell stocks and move back into interest-bearing instruments when yields become more attractive. It is our belief, however, that this is not necessarily the case. Steady, predicable, rising interest rates, in our view, generally point to an economy that is experiencing positive growth and modest inflation...which is conducive to increasing corporate profitability, and thus, potentially higher stock prices. There can be exogenous factors, of course, which impact short-term market valuations. However, this does not change our view over the long-term impact.

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The Enduring Qualities of Dividends

November 26, 2014

P e r c entag e Rate

20

10-Year Treasury and Fed Funds Rates, July 1954 - September 2014

18

16

14

12

10

8

6

4

2

0

1954M7 1955M6 1956M5 1957M4 1958M3 1959M2 1960M1 1960M12 1961M11 1962M10 1963M9 1964M8 1965M7 1966M6 1967M5 1968M4 1969M3 1970M2 1971M1 1971M12 1972M11 1973M10 1974M9 1975M8 1976M7 1977M6 1978M5 1979M4 1980M3 1981M2 1982M1 1982M12 1983M11 1984M10 1985M9 1986M8 1987M7 1988M6 1989M5 1990M4 1991M3 1992M2 1993M1 1993M12 1994M11 1995M10 1996M9 1997M8 1998M7 1999M6 2000M5 2001M4 2002M3 2003M2 2004M1 2004M12 2005M11 2006M10 2007M9 2008M8 2009M7 2010M6 2011M5 2012M4 2013M3 2014M2

Fed Funds Rate Source: ; Ameriprise Financial Services, Inc.

10-Year Treasury Rate

Short-term Examples

Morningstar recently published a study on interest rate cycles and dividends during some representative time periods where interest rates (as measured by the Fed Funds Rate and the 10-year Treasury rate) were generally rising. The table below was published in an April 17, 2013, paper entitled "Demographics and High-Dividend Equities" by Josh Peters, CFA (used with permission). During these representative periods of rising interest rates, the S&P 500 Index turned in healthy gains, as did the DJ U.S. Select Dividend Index. Note, though, the downdraft in dividendpaying stocks in 1999 ? 2000 ? we attribute this sell-off to the "tech bubble" period, as opposed to a reaction to rising interest rates.

Interest Rate Cycles and Dividends Start End Equity Performance

Jan. 1994 - Feb. 1995

Fed Funds

3.25%

10-Year Treasury 5.75%

6.00% 7.47%

Total Return: DJ U.S. Select Div. Total Return: S&P 500

+5.88% +4.45%

May 1999 - May 2000

Fed Funds

4.75%

10-Year Treasury 5.54%

6.50% 6.44%

Total Return: DJ U.S. Select Div. Total Return: S&P 500

-10.46% +10.48%

May 2004 - June 2006

Fed Funds

1.00%

10-Year Treasury 4.72%

5.25% 5.11%

Total Return: DJ U.S. Select Div. Total Return: S&P 500

+25.32% +17.75%

Monthly data 1994-2006. "Return" is total return including dividends for the period. Source: , Morningstar.

Past performance is not an indicator or guarantee of future performance, and it is not possible to invest directly in an index. These figures do not include transaction fees or taxes, which would have reduced returns.

Long-term Viewpoint

Rising interest rates would make us concerned, as shown in the chart below (used with permission from S&P Capital IQ), in unusually high interest rate environments. Historically, when 10-year Treasury yields are higher than 6%, stocks have generally decreased in price. The worry here is that rates are high because expected inflation is high. High inflation erodes purchasing power for consumers, and can also negatively impact corporate profit margins. This type of environment is generally not conducive to expanding equity valuations.

Median Monthly % Change in S&P 500 During Periods of Rising 10-Year T-Note Yields: April 1953 - October 2014

2.00%

1.65%

1.70%

1.50%

1.31%

1.00% 0.50%

0.74%

S&P 500 % Change

0.00% -0.50%

0%-3%

-1.00%

3%-4%

4%-5%

5%-6%

10-Year T-Note % Yield

-0.03% 6%-7%

7%+ -0.54%

Source: S&P Capital IQ. Indexes are unmanaged, statistical composites and it is not possible to invest directly in an index. The returns shown do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back tested performance to be lower than the performance shown. Returns exclude dividends and taxes. Past performance is no guarantee of future results.

? 2014 Ameriprise Financial, Inc. All rights reserved.

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