If You're Missing Dividend Stocks, You're Missing Out

It's Wall Street's best-kept secret. America Inc. is falling over itself to hand out scads of cash to shareholders -- $155 billion in dividends in 2003 -- but investors are reacting as suspiciously as they might to someone trying to give away $10 bills in Times Square. The result: Despite the powerful runup in the major market indexes, dividend-paying stocks are still a terrific buy, especially given that, tax-wise, the spurned dividends are now as valuable as capital gains.

Clearly, investors are thinking about dividend stocks the wrong way. They're treating them as if they were the boring country cousins of go-go growth stocks. They'd do better by regarding them as bonds that pay out increasing amounts of income over time -- as well as healthy capital gains over the long haul. Sound far-fetched? Well, 58 stocks have paid increasing dividends for 25 years or more. Once the public catches on, says Warren E. Spitz, who manages $5 billion for American Express Financial Advisors, "I suspect there will be a permanent shift by investors looking to equities, rather than bonds, for income."

Still not convinced? Just run the numbers: $10,000 invested in the Standard & Poor's 500-stock index in 1982 would have started yielding more each year than the Lehman Brothers Aggregate bond index after just a decade. That's because dividends tend to rise over time, while the interest paid by bonds remains fixed. Over 20 years the stock portfolio would have paid out dividends totaling $18,166, beating the $17,836 earned by the bond portfolio. What's more, the value of the stock portfolio would have grown more than sixfold, to $62,558 -- despite the 1987 crash and the 2000-03 bear market.

Investors may not have yet discovered the allure of dividend-paying stocks, but companies certainly think they will eventually. In 2003, no less than 241 companies in the S&P 500 increased their dividends through Dec. 12. Reversing a 20-year trend, a record 21 companies initiated their first-ever dividends -- including Microsoft Corp. (MSFT ), which announced a dividend in March and then promptly doubled it, to 16 cents a share, in September.

It's not too late to jump on the bandwagon. The relative underperformance of dividend stocks in 2003 means there are still plenty of bargains to be found. For example, banking giant Citigroup Inc. (C ) increased its payout twice, to a total of $1.40 for the year -- a yield of nearly 3% at its mid-December price. Picking likely candidates isn't brain surgery.

Cream of the crop

Don Taylor, who manages $2.1 billion for Franklin Resources Inc. (BEN ), has honed the technique. His Franklin Rising Dividends Fund focuses on companies that raise dividends systematically year after year and have at least doubled them over the past decade. "I want the business to generate high returns on investment capital and generate cash, and what they can't invest intelligently, I want them to give back to me," he says. That boils down to a couple of hundred stocks. Taylor then picks about 50 for his fund. His top picks read like an honor roll of America Inc.: General Electric Co. (GE ), which yields 2.6% at current prices; giant insurer American International Group Inc. (AIG ) (1.4%); and drugmaker Pfizer (PFE ) (1.9%).

Real estate investment trusts pay out almost all their earnings in huge dividends -- it's the law. Since those dividends are not taxed at the corporate level, investors are not disadvantaged by double taxation, and the new law does not apply. Even so, some are worth a look.

The most generous dividend-payers are to be found mainly among Old Economy companies and slower-growth sectors, such as utilities, industrials, and financials. Franklin Resources' Taylor is enthusiastic about the prospects for Washington Mutual Inc. (EM ), even though it warned the Street on Dec. 9 of lower earnings. He sees prospects for growth in retail banking and ample room for cost-cutting in its mortgage business. Since the last quarter of 1995, the Seattle bank has increased dividends every quarter. And with a yield of 4%, it's one of the highest-paying stocks in his portfolio. Another pick is insurer Old Republic International Corp. (ORI ), which has paid dividends continuously since 1942. It just declared a $1-per-share special dividend on Dec. 4 on top of a quarterly dividend of 17 cents, for a total yield of 1.8%.

For his money, American Express' Spitz favors property and casualty companies -- such as the soon-to-merge Traveler's Property Casualty (TAPA ) and St. Paul (SPC ), and Ace Limited (ACE ) -- over banks. "We're pretty bullish on the economy, and banks are important beneficiaries, but insurance companies are cheaper," he explains. While electric and natural-gas utilities will do well in 2004, Spitz says the biggest bang will come from oil companies, such as ChevronTexaco Corp. (CVX ) and Marathon Oil Corp. (MRO ), that will benefit from rising prices and falling supply. One of Spitz's funds is the AXP Diversified Equity Income Fund, which invests 80% of its assets in dividend stocks. It was up 31% in 2003, as of Dec. 12, thanks to such stocks as Citigroup, Caterpillar (CAT ), and Ingersoll-Rand (IR ). The fund has gained 9% a year since 1993.

Once the bailiwick of the most conservative investors, dividend stocks have had their share of blow-ups in recent years. Heavy debt plagues both the utility and telecom sectors: California's Pacific Gas & Electric Co., WorldCom, and others are still working their way out of bankruptcy.

But investors can still find plenty of winners. Tom Huber, manager of the $660 million T. Rowe Price (TROW ) Dividend Growth fund, says a "bulge of bigger dividend increases" is still in the pipeline for early 2004. He anticipates that dividends in his fund will grow by 8% next year. "The stars are aligned for traditional dividend-paying stocks and higher-quality companies," he says. That's good news for dividend-stock mavens -- and a heads-up for hesitant investors.

By Mara Der Hovanesian

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