For the creditor class, people who count on drawing income from their bond portfolios, the Federal Reserve's steady hikes in short-term interest rates are welcome. As far as they go. Still under 3%, the yields on five-year, AAA-rated municipal bonds won't be funding many ocean cruises this winter.
That's why I've been keeping my eye on an alternative: dividend-paying stocks. In January, 2003, just after President George Bush declared his plan to ease taxation of dividends, I set out to put together a solid portfolio of dividend payers (BW, Jan. 27, 2003). Since then, its seven stocks returned 27%, with dividends reinvested. That's not the 31% delivered by the Standard & Poor's 500-stock index over the stretch, but it easily beat bonds and money funds. After Washington did in fact cut taxes on most dividends to 15%, I assembled a second portfolio of nine dividend-paying stocks (BW, Sept. 29, 2003). It did even better, a return of almost 34%, vs. the S&P's 14%.
TRUST ME, RETURNS THIS BOUNTIFUL came as a surprise, and I don't expect an encore given how interest in dividend stocks has grown. Morningstar just launched a newsletter, DividendInvestor, while the virtues of dividends is a main theme of The Future for Investors, the latest book by Wharton School finance professor Jeremy Siegel. Just the same, until interest rates have moved considerably higher, I remain intrigued by the possibilities of gaining more income on a portfolio of relatively stable stocks than with bonds, which are threatened by inflation and higher rates. A typical intermediate-term muni bond fund would see its portfolio fall 5% for each percentage point rise in rates.
So, working with an S&P database that's sold to financial advisers, I searched for stocks with market values of $3 billion or more and dividend yields between 3.7% and 6%. (The lower number is a bit more than the yield on a five-year Treasury bond; beyond 6% could be a warning of a dividend cut ahead.) I excluded real estate investment trusts, limited partnerships, and foreign stocks, because they generally fall under different tax rules. Finally, I asked the database to return the names only of those stocks that S&P has deemed above average for the stability of their earnings and dividends. Result: 20 names, most of them familiar.
Among them, I next looked for expectations of profit growth and diversification by industry and settled on eight: three financials, three utilities (each in a different region), one food, and one drug stock. The latter, Merck (MRK ), may be the most controversial choice, given its declining sales and legal liabilities over the recall of Vioxx. Yet its high research spending may be the source of future cash flows, while dividend payments have run under 39% of operating cash flow. At Bristol-Myers Squibb (BMY ), which I passed over for Merck, dividends have eaten 65% of cash flow. ConAgra Foods (CAG ), which returned 25% since I included it in the January, 2003, portfolio, also made the cut. It's now out of such commodity lines as fresh meats, so higher-margin packaged foods make up 83% of sales.
Just one of the stocks in my 2003 income portfolios, Russ Berrie, had a negative total return, down 0.6%. To expect such good fortune again would be foolish. Yet these eight stocks as a group have been relatively stable, suffering just 25% of the S&P 500's volatility. They yield an average of 4.4%, which after a 15% tax leaves 3.7%. That won't make you rich, but it does raise a question: What have your bonds done for you lately?
By Robert Barker