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Diving For Dividends

By: Investor Solutions

By: The Financial Planning Association

Should stock dividends be in your investment future? With market observers questioning whether stocks will return any time soon to the double-digit growth they experienced during the 1990s, and with questions raised about the accuracy of corporate earnings in the wake of Enron and Global Crossing, some investment experts say dividends are worth a closer look.

During the booming market of the 1990s, many investors scoffed at dividends’ quarterly cash payouts to shareholders from corporate earnings”because they were far more interested in stocks with the potential for big price appreciation. Ten years ago, the average dividend yield” the annual dividend divided by the current market price for the S&P 500 Index was 3.3 percent. Today it stands around 1.3 percent.

Numerous companies, including large ones such as Microsoft and Cisco, don’t pay dividends at all. In the mid 1970s, one-third of the companies that went public paid a dividend, according to finance professors Eugene Fama and Kenneth French.[Dividend computer file] By 1999, only 3.7 percent of the new publicly traded companies paid a dividend.

Taxes figured into the appeal of growth companies, as well. That’s because dividends are taxed twice, first at the corporate level and then at the investor’s level and they’re taxed at the investor’s ordinary tax rate. On the other hand, capital gains from price appreciation are taxed only at the investor’s level, and then generally at a rate lower than the ordinary rate. The clamor for appreciation by investors grew so strong during the 1990s that corporations minimized or ignored dividends and plowed profits back into their companies with the idea of more than making up the forgone dividends through price gains.

Despite the declining dividend yield, stock dividends have remained a significant, if overlooked, component of overall stock returns. For example, the 10.7 percent average annual return of the S&P 500 since 1926 would have dropped to 6.3 percent without reinvested dividends, according to the Leuthold Group. Even in the low-dividend 1990s, reinvested dividends accounted for 3.1 percent of the 16.9 percent average annual gain, according to The Vanguard Group.

Furthermore, one of the advantages of dividend-paying stocks, say some experts, is that they cushion the blow of declining stock prices better than companies that don’t pay dividends. Remember, to pay out dividends, a company must have earned a profit. In fact, a study by Standard & Poor’s found that 47 stocks that consistently increased dividends in the last decade outperformed the S&P 500 Index.

So back to the opening question: should dividends be in your future? Who should consider dividend stocks (or mutual funds that buy dividend-paying stocks), and what should they look for when buying them?

Dividends have traditionally appealed to two types of investors regardless of how stocks are doing overall: older investors looking for cash income, and more conservative investors who’d rather receive cash in hand than count on gains that might evaporate in a bad market.

Now even some growth-oriented investors have grown skittish in the wake of the down market, and are asking non-dividend-paying companies such as cash-loaded Microsoft to start paying dividends.

If the idea of dividends appeals to you, keep some of these points in mind when choosing stocks:

Pick a stock because it represents a good company with a good opportunity to grow in price, not just because it pays a dividend.

  • You can postpone paying taxes on dividends if you hold the stocks or stock funds in a tax-favored retirement account or IRA.
  • Consider interest-paying alternatives such as money markets, certificates of deposit and bonds if you’re looking strictly for income, not growth. Many dividend yields currently beat money market and CD returns, but that’s not always the case.
  • Unusually high dividend yields may be a sign of a company in trouble, say experts. Dividend yield will rise, for example, if the stock price falls while the dividend payout remains the same.
  • Because the market is down, some companies are offering dividends as a way to attract investors. Again, it may be a sign of a company in trouble.
  • Generous dividends aren’t guaranteed. Numerous companies have drastically cut their dividends as their cash flow tightens in this down economy.
  • Studies show that high-dividend stocks tend to lag behind low-dividend stocks when the market takes off.

This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Frank Armstrong, a local member in good standing of the FPA.