How to benefit from the 'fear factor'
The current volatility in the markets can be seen as an opportunity.
As investors, we seek safety and security for our investments — something that is far easier to find when uncertainty is not ruling the world's economies. These days, however, the only certainty we can find in the global economy is change.
Continued concerns about the economies in Europe and the U.S. have been roiling the markets and testing our ability to tolerate uncertainty. The CBOE Volatility Index, also popularly known as the "Fear Gauge," which in normal markets is around 20, has jumped to over 30. But it's important to realize that market volatility also creates opportunity. While periods of market upheaval can cause fear and panic, they can also uncover chances for profit.
Consider billionaire investor Warren Buffett's advice in 2001 when asked about the secret to his long-term investing success. He said, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
Benefiting from the fear factor
The recent sell-off in the markets has meant that the S&P TSX Composite Index is now trading at 13.2 x 12 month forward earnings, and the U.S. large cap companies as measured by the S&P 500 index are trading at 12 times forward earnings. The price/earnings ratios of both these indices are trading at a discount to their respective average over the past 10 years.
When looking for investment opportunities, particularly attractive in this environment are dividend yields. The dividend yield on the S&P TSX Composite index is at 2.7 per cent. This compares with the 10-year Government of Canada bond which yields just 2.15 per cent. The Canadian financials sector has an average dividend yield of 4.1 per cent and telecom and utilities are also around 4.3 per cent.
In the U.S., the dividend yield on the S&P 500 is at 2.1 per cent and the 10-year U.S. Government bond yields 1.95 per cent. The utilities sector has a yield of 4.2 per cent and consumer staples are at 2.9 per cent%. In effect, you are being paid to wait out this period of heightened market volatility.
Dividend Aristocrats Index
There are 42 companies that currently make up the S&P 500 Dividend Aristocrats index. These are large cap companies that are part of the S&P 500 Index and have a track record of increasing dividends for at least 25 consecutive years. These include familiar names such as Coca Cola, McDonalds, Kimberly Clark and Clorox.
In Canada we have the S&P Canadian Dividend Aristocrats index. There are 39 companies that currently make the list. These companies have followed a policy of increasing dividends for at least five consecutive years. Included here are names such as Canadian National Railway, Tim Horton's, TransCanada, Shoppers Drug Mart and Enbridge.
Most economists are predicting that the sovereign debt crisis will mean slower than expected economic growth over the next couple of years. If economic growth is slower, price appreciation opportunities will likely be more limited. As well, the U.S. Federal Reserve is on hold for raising interest rates until mid-2013. If interest rates remain at the current exceptionally low levels, then dividend yields look attractive as sources of income.
In addition, a stable dividend payout can provide support to share prices relative to stocks which do not pay a dividend.
What to look for in a dividend stock
On the Canadian side, research large cap companies with earnings growth greater than five per cent, sustainable dividends (payout ratio of under 65 per cent), and a minimum current dividend yield of two per cent and a record of growing dividends for at least five consecutive years.
South of the border, there are a lot more options to choose from, so it's possible to tighten the criteria. Screen for large cap S&P 500 companies with a minimum 10 per cent earnings growth, maximum payout ratio of 65 per cent, minimum dividend yield of two per cent, and a record of growing dividends for at least 10 consecutive years.
It's important to stress that when it comes to dividends you are not chasing stocks with the highest yield. You are looking for companies that can sustain and grow their current dividend as well as reinvest in their businesses.
The online screening and research tools available through your brokerage could help you shortlist stocks based on your investment parameters and research them to make well-informed decisions.
An alternative approach would be to consider a well-managed dividend income or dividend growth mutual fund with strong long-term historical performance. This will give you access to professional fund managers with focus on a disciplined long-term vision and risk management.
Those who prefer passive management can consider a dividend ETF. The dividend mutual fund or ETF will give you exposure to a diversified basket of dividend paying stocks and you could potentially save on time needed to research individual dividend paying stocks as well as commissions needed to create your own basket of such stocks.
Finally, when written in Chinese, the word "crisis" is composed of two characters. One represents danger, and the other represents opportunity. When uncertainty settles in, as it has done with the global economy, it may be wise to let "opportunity" tilt your investment plans toward dividend-paying stocks.
MSN.ca Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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