The bigger the better, right?

It’s the American way. It’s easy to become enamored with large-cap tech stocks. Of course, every investor wants the best possible returns for their portfolio. All investors are susceptible to thinking that great results can only come from big tech companies that continuously pump out large profits.

I am here to tell you otherwise. Dividend-paying stocks can provide outsized returns – in some cases better than many technology stocks – all with relatively lower risk. This is what makes the dividend strategy one of my favorite strategies. I think every investor should consider owning dividend-paying stocks as part of their overall portfolio.

U.S. companies paid out a record $574.2 billion in dividends to shareholders last year. Dividends in the U.S. grew a substantial 7.6% in 2022, with 94% of dividend payers either raising or sustaining payments. Corporate balance sheets remain healthy, which is vital for future dividend growth.

There’s no doubt that 2022 was a challenging environment for stocks. Yet, it highlighted the many strengths of dividend equities, which outperformed non-dividend stocks and bonds during the year. And many of these companies have continued their outperformance into 2023.

The Power of Dividends – An All-Weather Investment Strategy

Dividend-paying stocks can help reduce portfolio volatility while also providing a degree of inflation protection. Many dividend-paying companies are able to pass on higher costs by raising their prices, exhibiting a high degree of pricing power. We saw this last year as many dividend payers not only held up well amid the bear market, but witnessed substantial appreciation as sectors such as consumer staples and energy outperformed. The dividend strategy is one that has the potential to outperform in multiple economic scenarios.

Companies that generate enough free cash flow to pay and increase dividends with consistency tend to be stable businesses. The positive impact that stems from quarterly cash payments becomes more valuable as investors seek to reduce risk. Given an uncertain economic environment, the demand for near-term and predictable cash flows increases.

Inflation impacts fixed income and equity securities in a fundamentally different way. Most fixed income instruments are predicated on a contractual payment for a set period, and as such, bond investors assume substantial inflation risk. Dividend-paying companies, however, can increase their dividends over time, enabling investors to grow their income stream and potentially hedge against the effects of inflation.

Dividend Growth – A Subtle Yet Reliable Indicator 

Contrary to conventional wisdom, the opportunity still exists for investors to create a reliable stream of income from the equity markets. One of the best ways to increase returns is to compound dividends received. Over time, reinvesting dividends can have a significant impact on overall portfolio returns.

It helps to gain a perspective of the role dividends have played throughout history. Dividends and their reinvestment represent a major portion of a stock investor’s total return over the long run. An examination of equity returns dating back 30 years dramatically illustrates this property.

An investor in the S&P 500 would have realized a +1,542.4% total return over the last 30 years. Excluding dividends, that return would have been reduced to +818.8%. This demonstrates that dividends represented nearly 47% of the total return over the 30-year period. Price appreciation is the glamor that investors tend to focus on, but dividends are the slow and steady engine that drive portfolio returns over the long run.

I prefer to target companies that have a history of raising dividends, even during uncertain times such as the current market environment. I have found the dividend growth rate to be a reliable forecaster of future earnings growth.

Corporate directors know their companies better than anyone else. They know the financial condition of their business, along with the outlook for its future earnings growth. They will only raise dividends if they truly believe that future earnings will be able to sustain higher dividend payouts.

A consistently rising dividend trend subtly reveals a company’s progress and is one of the best indicators of a healthy, growing enterprise. Using this simple yet effective strategy of investing in companies that consistently raise their dividends, investors can harness the power of compounding income. There are no complex formulas or calculations required.

The Zacks Income Investor service reverses the conventional wisdom that high returns must come with high risk. One of the goals of this service is to achieve above-average returns with relatively low risk. Our aim is to make profits during both bull and bear markets. Over the years, I’ve learned that simple is better – both in life and investing. The more complicated a strategy is, the less likely it is to work in the future.

Health Care Dividends – Underappreciated and Undervalued

The Zacks Medical sector is comprised of companies dealing in biotechnology, pharmaceuticals, health care providers, medical supplies, and medical devices. The sector is not generally known for having impressive yields, but health care companies have proven that they are committed to being consistent dividend payers. Zacks Income Investor has exposure to health care companies, and we are planning on increasing that level very soon.

Health care companies bring the best of both worlds. They’re historically viewed as a defensive area of the market that is relatively immune to economic volatility, but patients require care regardless of the state of the economy. Last year saw strength in many health care industries, and these same industries are still outperforming even as stocks have started to rise this year.

Yet irrespective of the defensive theme, high levels of innovation are taking place in health care. We’ve all heard of the popular artificial intelligence (AI) products this year, including chatbots like ChatGPT. But one area that is not getting enough attention is health care. The emergence of AI in health care has been revolutionary, reshaping the way we diagnose, treat and monitor patients. More personalized treatments along with more accurate diagnoses are just a few of the ways AI has benefitted this space.

Hospitals, clinics, and health care providers are leveraging artificial intelligence to analyze vast amounts of documentation, enabling medical professionals to quickly identify health care solutions that would otherwise take much longer. From scanning images for early disease detection, to predicting patient outcomes via machine learning, the potential applications of AI and health care are extensive.

As humanity moves forward into a more digital world, the use of AI in the health care sector will reshape the doctor-patient relationship. The future of health care is bright and filled with endless possibilities of innovative advancements, improved outcomes and better patient experiences. When we combine the solid dividend growth of health care companies with the potential for substantial price appreciation due to explosive growth prospects, we have a recipe for success.

Final Thoughts

I think dividend-paying stocks are more important than ever. With the corporate earnings outlook uncertain at best, these steady, income-producing equities with strong balance sheets and a history of raising dividends are an investor’s best friend. Compounding returns using the dividend strategies we mentioned above is a great long-term approach to building wealth.

Stock market performance can be difficult to predict, but dividend investing remains a sound strategy. Health care stocks represent a great mix of reliable dividends and potential price appreciation given AI breakthroughs. If market volatility remains present as it was last year, dividend stocks should perform well, even if the U.S. enters a mild recession. If markets continue to surprise to the upside as they have to start the year, dividend equities will likely participate in the recovery.

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