Why dividend payers deserve another look

Income stocks have been out of favor lately. But by balancing your portfolio, they can provide safety in a down market.

By Ken Terry
Senior Editor

If stocks that pay dividends consistently over the years play little or no role in your portfolio, it's not surprising. Over the past decade, investors have turned more and more to growth stocks, which have outperformed everything else. And the companies that issue growth stocks have increasingly eschewed dividends in favor of plowing profits into more growth.

But if you're missing out on consistent dividend payers, you could be missing a good way to help keep your portfolio balanced. Dividend payers tend to be strong companies that lose less value during market downturns than aggressive-growth stocks do. Dividends can help boost total returns when growth is slow, too.

Opting for dividends, moreover, doesn't necessarily mean forsaking growth; in fact, it can mean the opposite. Arthur J. Bonnel, portfolio manager for US Global Investors' Bonnel Growth Fund, based in San Antonio, did a study of 38 stocks whose dividends increased every year from 1976 to 1999. While the Standard & Poor's 500 Stock Index returned an average of 11.5 percent per year during this period, he says, the 38 stocks on his list returned 15.4 percent annually, exclusive of dividends.

"The rate of return is phenomenal on these companies," says Bonnel. "They're very good investments, but you need a long-term horizon."

The dividends themselves won't make you rich. Granted, nearly half of the total return of the firms in the Dow Jones Industrial Average has historically come from dividends. But the average stock in the S&P 500 is currently yielding only 1.2 percent of its market value, less than the rate of inflation. Even the average stock on Bonnel's list paid just 2.1 percent in dividends as of November 1999.

Utilities have yielded 4 to 6 percent for the past few years, but the increased competition that resulted from deregulation has made future dividends hard to predict. Real estate investment trusts, required by law to pay investors 95 percent of their earnings, are currently paying an average of 8.1 percent. But if your tax bracket is 31 percent or higher, even those high dividends supply hardly any more income after taxes than a tax-exempt municipal bond yielding 5 percent.

Consequently, you should evaluate dividend-producing stocks just as you would any other type of security. "The investment decision should always be driven by what that asset's going to be worth five years from now," says Michael Stolper, whose San Diego-based firm, Stolper & Co., helps wealthy clients pick money managers.

But many experts see steadily rising dividends as a factor predicting that growth. "You're looking at companies with the depth of management that can sustain earnings growth," says Bonnel. "They have the management philosophy and the desire to continue to enhance shareholder return and value, and that's what they're focusing on."

Dividend-producing stocks aren't inherently less risky than other equities. But they tend to be more mature and, therefore, less volatile than hot growth stocks. Although they shouldn't be the backbone of your portfolio, they can help balance it. Buying some dividend stocks "provides diversification—they're not high-tech stocks that can crash and burn," says Bonnel. "These will give you a little more warning."

As even Bonnel acknowledges, though, a stock's dividend is no hedge against negative trends in an industry or the economy as a whole. Many people believe that if the Fed raises interest rates, owning dividend-paying stocks "will cushion the blow," he observes. "But when yields are averaging less than 2 percent, that's no cushion. They'd have to go to the 6 percent level before they'd provide some safety."

The ABCs of investing in dividend stocks

If you're considering buying individual dividend stocks, Bonnel advises, pick at least half a dozen. That way, when one is going through a slow period, others may be surging ahead.

Maybe you don't have the time or patience to follow individual stocks. In that case, buying a growth-and-income or equity-income mutual fund may be the way to go. But even with these, you need to do your homework. Not all funds are created equal, and many that call themselves equity-income funds actually depend on growth stocks to boost their returns. Here's a list of some top-performing funds.

Also keep in mind that equity-income funds have returned an average of 14.8 percent annually for the past five years, compared with 19.9 percent for aggressive-growth issues. So don't expect these funds to set the pace for your portfolio.

And whether you buy equity-income funds or individual securities, you'll pay a little more in taxes for dividend payers, because dividends are taxable as ordinary income. If you invest in non-dividend-paying growth stocks, you'll owe capital gains tax instead, which is generally lower, and you'll pay it only after you sell the stock.

To maximize your first-year return on a dividend stock, buy it at least five days before its payout, which is usually distributed once a quarter. Otherwise, you won't receive a dividend for that period, because you won't be a "shareholder of record." If a stock is within the five-day window, it will have an "x" next to its name in the stock tables in the newspaper.

Of REITs, Baby Bells, and other opportunities

So what should you buy? Real estate investment trusts are popular among financial advisers because of their high yields and growth prospects. Although these stocks have underperformed the market in recent years, some should do quite well in the future, says James F. Ferrare, a senior portfolio manager for Pinnacle Associates, a New York money management firm. Ferrare particularly likes REITs that invest in apartment buildings, because he foresees a booming rental market as mortgage interest rates rise.

Fred Lynn, president of F.A.L. Capital Management in Scottsdale, AZ, also favors REITs. "This market shows signs of being strong for several years. Zoning is much more difficult than it used to be, so whatever properties these trusts own will increase in value as it becomes harder to put up new buildings in many cities," Lynn says.

You might also consider utilities, another group of dividend-producing companies. Like REITs, they offer above-average yields, and at least until recently, those yields have been fairly predictable. Although some utility boards have cut dividends in order to play in a more competitive market, the flip side is that this has enhanced the growth prospects of some utility stocks.

"You're seeing one of the largest consolidations in the history of America, where electric power has become fungible and commodity-like," says Mike Stolper. "It's not going to be a regional or local monopoly. You have this replication of generation, repair, and billing facilities that are contiguous throughout the country," he points out, referring to the potential economies of scale attainable through mergers.

Another utility-like sector, regional telephone companies, has picked up because of wireless communication and the Internet. Ferrare thinks these Baby Bells offer a lot of potential: "The regional Bell companies have had slow growth, but they're exciting because they're going to put high-speed Internet access into your house. GTE merged with Bell Atlantic, which became Verizon and is one of the largest phone companies in the country. Bell South and SBC Communications plan to merge their wireless assets, create a tracking stock, and spin it off to the public. So there's a lot of magic in these names." (A tracking stock is a new offering of stock from an established company, issued to showcase a division of the company and give it a separate identity from the corporate parent. The tracking stock's dividend is based on the performance of that particular corporate segment.)

Stolper basically agrees with Ferrare, but warns that there will be losers as well as winners as these deregulated companies adopt a more aggressive growth strategy. "They're doing more acquisitions and are borrowing money to do it," he says. "Some will stumble and will be consolidated because they can't survive independently."

Top-performing dividend-paying growth stocks, 1976-99¹ . . .

¹Excerpted with permission from Bonnel Inc.'s report, "Companies Raising Their Dividends Every Year Since 1976." The full list includes 38 firms, excluding banks, insurance companies, and utilities. The companies listed here had the highest average annual percentage returns during that period. ²Capital appreciation only; excludes dividends. ³The ratio of current dividend to average purchase price in 1976.

All figures as of Oct. 31. All stocks trade on New York Stock Exchange.

Source: Standard & Poor's

Mutual funds that focus on dividend-paying stocks

¹Through Oct. 31. Dreyfus Premier Large Company Stock, GE Value Equity, and Waddell & Reed Advisor Core Investment have 5.75 percent up-front loads; all other funds are no-load.

Source: Morningstar

 

Ken Terry. Why dividend payers deserve another look. Medical Economics 2000;24:64.