Dividends: Smart Plays for Tight Times

Investing in companies that have a proven history of raising their dividends has been a popular strategy among stock-market players over the years. But lately, finding firms that continue to boost their payouts has been getting harder.

Standard & Poor's said on Oct. 1 that only 191 out of 7,000 companies that report dividend information to S&P boosted their dividends during the third quarter, down nearly 45% from a year earlier. That makes the just-completed quarter the worst ever for rising dividends. It was also the worst third quarter for dividend cuts since 1982, with 113 companies reducing their cash payouts, S&P said.

The worst may be over in terms of dividend cuts or eliminations, according to S&P. But even if the economy responds to the Obama Administration's stimulus programs, companies may still not feel comfortable enough to raise or re-initiate payments until they have seen several quarters of improving financial results, S&P added.

Don Taylor, portfolio manager of Franklin Templeton's Rising Dividends Fund (FRDTX), agrees with S&P that dividend cuts "are largely behind us," and expects some companies that have trimmed their dividends in the past year, such as some banks, to start raising them again within the next six months. Nor would he be surprised, he says, if Pfizer (PFE), which slashed its dividend when it announced it was buying Wyeth earlier this year, starts to increase it by the end of this year or the early part of 2010.

Disappointing FundsHe notes that the vast majority of banks no longer qualify to be included in his fund because most have either cut their dividends or, if they have accepted money from the Treasury's Troubled Asset Relief Program, are prohibited from raising their dividends until they have paid it back.

The returns of most dividend-focused funds so far this year generally have been disappointing. These funds have underperformed because they don't invest in the lesser-quality, higher-risk stocks that don't pay dividends, which have been favored by the market since the rally began nearly seven months ago.

Taylor's fund was up 10.97% year-to-date as of Sept. 30, lagging the large-cap blend category by more than 10 percentage points and the S&P 500 index by 8.3 percentage points. The Franklin fund has been hurt by not including shares of big non-dividend-paying gainers such as Apple (AAPL).

Taylor prefers stocks he thinks are more likely to increase their dividends over the long term over ones currently paying high yields. Two that fit the bill are among the more defensive consumer staples names—Family Dollar Stores (FDO) and Wal-Mart (WMT). When it comes to retailers, the market lately has been focused on companies with greater potential for a big snap-back from several quarters of depressed sales, while companies that were able to consistently increase same-store sales during the downturn—such as Wal-Mart and Family Dollar—have been ignored in the rally.

"Longer-Term Phenomenon""We value that consistency and predictability and the appeal that they have to the consumer," says Taylor. "People have gotten more frugal, more careful. They're looking for discounts. It's not just cyclical, it's a longer-term phenomenon, and companies that appeal to that mindset will continue to benefit."

The main weight on stocks that continue to increase their dividends is the industries they tend to be in—defensive sectors such as health care and consumer staples—are viewed by investors as less sensitive to the economic recovery than higher-risk stocks that were more badly beaten in the downturn. Among dividend payers, only natural gas pipeline and storage limited partnerships and real estate investment trusts (REITs)—"two high-payout groups that aren't always a part of a traditional dividend strategy"—have kept up with broader market gains, Josh Peters, an equity strategist at Morningstar (MORN), wrote in the October edition of his monthly Dividend Investor newsletter. But he thinks this is a bad time to be chasing market momentum.

"I'd rather not be making active bets on whether the economy is going from boom to bust and just stick with stocks that offer [steady growth and income]," says Peters. "It may be frustrating, but it opens up a relative value opportunity. You can start to look at some names now that are less expensive than a couple of years ago. You can pick up a lot of quality and income relative to the market, and you're getting more a defensive posture for whatever the economy might bring."

He's wary of companies that are paying too much for acquisitions such as Pfizer and Kraft Foods (KFT), probably at the expense of being able to raise their dividends over the next couple of years. While he still owns Kraft shares, he says it's not a coincidence that after the company announced plans to buy Cadbury in September it decided not to increase its dividend.

Leveling Off?Abbott Laboratories' (ABT) decision to buy Belgian pharma Solvay is wise from a financial perspective because Abbott is using cash earned from its overseas operations to invest in a business that can generate higher returns than it was earning on the cash, says Taylor at Franklin.

Abbott has said it expects the acquisition to add 10¢ a share to 2010 earnings and double that in 2011. Solvay will also boost Abbott's presence in certain product categories and end markets, he says.

But Taylor believes the broader market is ready to pause in its upward trajectory and will want to see proof that the low-quality companies that led the rally can grow their earnings enough to justify the appreciation in their share prices since March. That should prompt investors to take a closer look at higher-quality stocks that consistently raise their dividends, he predicts.

One dividend-paying company isn't defensive and may even be more sensitive to an economic recovery than some recent winners: Automatic Data Processing (ADP), a dominant player in payroll services. The company will also grow by using existing customer relationships to sell ancillary services such as human resource management, says Christian Andreach, managing director at Manning & Napier, an independent investment advisor that owns shares of ADP in some of its portfolios. The stock has a 3.4% dividend yield and is trading at 16.6 times estimated earnings for fiscal year 2010.

Uphill BattleThe stock is up 18.4% since March 9 but is somewhat hamstrung by two key macroeconomic drivers working against it, First there's the pessimistic employment outlook, and second, depressed interest rates that restrict the interest income the company earns by holding the money it gets from customers for a period of time before paying its customers' employees, says Andreach.

When the jobs picture does pick up, it should work in ADP's favor, as should a monetary policy by the Federal Reserve that will allow interest rates to start rising again sometime in the second half of 2010, he says.

Investors who believe the equities rally has run its course for the time being and think they'll be better off holding higher-quality stocks than most of those that have led the rally will look to large-cap dividend-paying names with cheaper valuations such as Johnson & Johnson (JNJ), with a current yield of 3.5%, and even International Business Machines (IBM), with a yield of almost 2%, says Charles Carlson, editor of the DRIP Investor newsletter.

Aging PopulationLonger-term demographic trends should also favor dividend-paying stocks: An aging population will need more income and cash flow, and these stocks usually pay higher yields than money-market funds and Treasury notes and for now are also taxed at a lower rate than Treasuries, says Carlson.

That same population trend will work to the advantage of consumer staples companies such as General Mills (GIS) and Kellogg (K), since cereal consumption is typically higher among older people and its a high-margin product category, says Andreach at Manning & Napier. Both stocks have done reasonably well—up over 16% and 25%, respectively—since his company bought them in April. The shift by cash-strapped consumers from branded to private-label cereals that would have hurt these companies has been much smaller than expected, he adds.

Valuations on the stock market as a whole have climbed so much that investors are only getting a 2% dividend yield on the S&P 500 index, vs. the 3% to 6% yield they were getting 15 years ago, says Peters at Morningstar. "That's something all investors should be concerned about," he says. "My way of combating that, without saying I'm done with stocks, is to be careful with what I own."

Indeed, dividend investing can still be profitable, if you choose carefully—but it's not the slam-dunk it once was.

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