The Lure of Dividends

With growth stocks scarce, outfits that have increased shareholder payouts deserve a look. Just be sure it's long, hard, and skeptical

By Eric Wahlgren

Had it with analysts who talk up stocks to investors but trash them in private to colleagues and insiders? Fed up with companies that profess business is fine one day, only to disclose that they're fighting for survival the next? Then Wall Street experts say you may want to take a look at companies that are raising dividends. These days, increases in dividends -- the portion of earnings that some companies pay out to investors in quarterly installments -- may be a better gauge of an outfit's growth potential than any analyst report or company guidance, pros say.

Notes Lowell Miller, president and chief investment officer of investment firm Miller/Howard Investments in Woodstock, N.Y.: "At least the payment of a dividend every quarter shows there actually is cash and that investors have a chance to benefit in real time, as opposed to waiting for a promise in the future."

Indeed, in this investing climate, a bird-in-hand philosophy looks rather wise. Stocks that pay dividends performed better in the first nine months of 2002 than those that didn't, according to Standard & Poor's. The 350 dividend-payers in the benchmark S&P 500-stock index declined only 16.9% in the period, while the 150 others plummeted 39.4%.


  "Companies that pay dividends are usually more stable," says Joseph Tigue, managing editor of The Outlook, an S&P investment newsletter for individual investors and financial professionals. "In a weaker market, they're viewed as super-stable."

And this weak market's secret is that, despite the continuing economic slump, many dividends have been increasing. From January to September, 2002, 1,046 out of some 7,500 public companies that report to S&P raised their dividends, vs. 990 increases last year (see BW Online, 10/10/02, "The Check Really Is in the Mail").

"Companies feel like they have to reward shareholders for holding on to stocks," says Tigue. Corporations have also spent less money on acquisitions and stock buybacks, he adds, leaving them with more cash for dividends. What's more, they remain somewhat optimistic that earnings will improve in 2003, he says.


  The number of companies that cut dividends the first nine months of the year, often a sign business is on the skids, dropped 23%, to 58. And those that eliminated them fell 20%, to 47. S&P is forecasting that dividends on the S&P 500 will rise 2% this year, after falling 3.3% in 2001 and 2.5% in 2000.

Just because a company has been paying the same dividend year after year, or may even have raised its dividend a couple times, doesn't necessarily make it a worthy investment, analysts say. Other factors should be considered. Investors should look for companies that have a history of dividend hikes and for evidence that earnings are solid, says Richard Moroney, editor of Dow Theory Forecasts, an investment newsletter based in Hammond, Ind.

Moroney suggests that investors look for attractive dividend yields -- the annual dividend divided by the current stock price. In particular, Moroney says, stocks with dividend yields greater than those for the major stock indexes -- currently 1.95% for the S&P 500 and 2.5% for the Dow Jones industrial average -- could outperform in the near term.


  Take tobacco company Philip Morris (MO ). At its current price, the stock has a dividend yield of 6.6%, Moroney says. All it would need to do to provide a total return of 10% this year is appreciate an additional 3.4% in price. (Dividend yield is calculated at the price at which the stock was purchased.)

Even here, though, there are caveats. A higher dividend yield does not always mean a higher payoff, Moroney says. Scads of utility companies have dividend yields of 8% to 10%, he notes. But many are facing problems in the post-Enron environment and could end up decreasing or dropping their dividends. Says Moroney: "Don't fall for yields that are too good to be true, because they likely are. The dividends are likely to be cut."

One utility bucking the industry trend is Duke Energy (DUK ). Moroney thinks the stock could deliver good long-term returns when dividend yields are considered. Other stocks that he thinks could represent attractive long-term plays include drug companies Eli Lilly (LLY ), Merck (MRK ), and Pfizer (PFE ).


  As a general rule, Moroney suggests identifying companies with better-than-average dividend yields. Then, he says, look at their balance sheets, earnings power, history of dividend growth, and price-to-earnings (p-e) ratios. "If all those are favorable," he says, "then you'll probably get a stock that will provide you with good returns over the long haul."

S&P has identified nearly 40 stocks in the S&P 500 that have shown dividend growth of at least 7% a year over the last five years and that boast yields at least as high as the index' average. All are rated accumulate or buy by S&P, which has no investment-banking relationship with the companies it covers.

Among the highlights are payroll-services provider Paychex (PAYX ), which has raised its dividend about 42% a year over the past five years, and regional bank-holding company New York Community Bancorp (NYCB ), with about a 30%-a-year dividend increase over the same period.


  Here's one important consideration for investors. Investment advisers suggest that dividend-paying stocks be kept in nontaxable accounts such as IRAs, since dividends are taxed at your federal income tax rate.

Mutual funds that focus on high-dividend-paying companies could be one way to take advantage of the income potential of dividends while spreading the risk, experts say. T. Rowe Price Equity-Income (PRFDX ), American Century Equity Income (TWEIX ), American Funds Washington Mutual A (AWSHX ), and Capital Income Builder A (CAIBX ) have outpaced their peers and the overall market this year, says Christopher Davis, a mutual-fund analyst at Morningstar, the Chicago-based fund research company.

Among these funds' chief virtues in this environment, dividends provide a boost even when performance is middling. The funds also avoid the volatility of technology and telecom companies, Davis says. That's mainly because growth stocks in these sectors, which are in a terrible funk, typically don't pay dividends. New technology outfits traditionally plow their earnings, when they have any, back into the operation.

However, Davis says dividend funds are not great "stand-alone" funds for a portfolio. "They should be paired with growth exposure," he says. In that sense, diversification remains the best strategy for most portfolios, especially for investors with a long-term horizon. But with good growth stocks hard to come by these days, dividend-payers could provide decent returns until the stock market stops its slide.

Wahlgren covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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