An investment concept that fell out of favor 20 years ago has returned with a vengeance: stocks that pay you to own them.
During the past two decades, growth-oriented investors shunned companies that paid dividends, preferring instead to take their gains in the form of capital appreciation. As investors pursued “growth at a reasonable price” in the 1980s and “growth at any price” in the 1990s, dividends became viewed as out of date — no way to improve investment returns, an out-and-out waste of capital. Couple that with the double taxation of dividends — taxed first at the corporate level and then as ordinary income to shareholders — there should be little wonder why dividends and the companies that paid them lost their appeal.
But times have changed.
Thanks to the 2003 tax law, qualified dividends receive the same tax treatment as long-term capital gains, a maximum of 15%, down from the maximum ordinary income rate of 35%. Oddly enough, under current law short-term capital gains are taxed at ordinary income rates, so profit from the sale of stock held for less than one year could be worth less than the same amount received as income from dividends. The 15% maximum rate is set to expire in 2008. However, several positive trends improve the likelihood that provisions of the 2003 tax law will be made permanent. The re-election of George W. Bush and Republican control of Congress come to mind.
Additionally, the need for income and capital appreciation among Baby Boomers, those born between 1946 and 1964, will become increasingly important to this large demographic group as they enter long-term retirement. Therefore, while some of the elements of the 2003 tax law may come under pressure as lawmakers confront a mounting budget deficit, the current tax treatment of dividends may be one aspect that survives.
In addition to favorable tax treatment, investors are looking at dividend paying stocks for other reasons. First, although not a substitute for cash, many dividend-paying stocks compete well with low interest money market rates, currently 1.67-2.15%. Investors who like the current income they receive from bonds are drawn to dividend paying stocks, as well. Bond prices suffer in a rising interest rate environment, however. Acquiring bonds of shorter maturity mitigates this problem somewhat; unfortunately, shorter maturities also denote lower interest rates, and bond interest is taxed as ordinary income. Therefore, for investors seeking current income and growth, many advisors are recommending portfolios comprised of high-quality, short-term bonds and blue chip, dividend-paying stocks.
Second, as a result of the market downturn of the past few years, today’s investors prefer lower volatility investments.
According to a study by two professors, dividends may smooth an otherwise bumpy ride. Kathleen Fuller of the University of Georgia and Michael Goldstein of Babson College studied the effects of dividends and concluded that dividend-paying stocks outperform non-dividend-paying stocks in a bear market. Fuller and Goldstein believe the reason is that dividends communicate information regarding a company’s strength, and this information is of superior value when markets are struggling. Dividend payments constitute positive news amid a chorus of mostly negative news, reduced earnings forecasts and analyst downgrades.
The math helps, too.
Stocks with a solid history of paying dividends tend to hold their value; as their price drops, the rise in yield makes them more attractive to investors. This may explain why, according to a study by Investor’s Business Daily, during the 18 months following implementation of the 2003 tax law, the S&P 500 index rose 23.3%, while S&P 500 stocks that raised dividend payouts during this period increased 35.8%, not including dividends.
Today, as a result of the 20-year journey away from dividend-paying stocks, the majority of publicly traded companies do not pay dividends. In fact, companies that pay dividends account for little more than one-third of stocks found in most databases. A study by the University of California, however, revealed that in the early 1980s nearly half of the 4,000 leading U.S. companies paid dividends. In the early 1970s, almost 80% of publicly traded companies paid dividends — and yields were higher. The average yield of the S&P 500 index just 10 years ago, for instance, approached 3%, compared to less than 2% today. Apparently, one of the lost lessons of investment history is the considerable contribution dividends have made to total stock returns.
During the period from 1926 through 2003, dividends contributed 43% of the total return of the stock market as measured by the S&P 500 index.
Clearly, as experience should remind us, the past does not predict or indicate future investment results. Furthermore, a dividend investment strategy cannot guarantee a profit or insure against possible loss of principal. Investors need to do their homework. The financial strength, dividend history, and earnings prospects of targeted companies need to be determined.
For many, the more efficient way is to focus on mutual funds devoted to ferreting out the best dividend-paying companies. Investors should read the fund’s prospectus to determine what extent different types of securities are allowed in the fund, however, because not all dividends receive favorable tax treatment. Payments from REITs, for instance, do not. Also, as with long-term capital gains, the lower tax rate is lost if dividends are received in IRAs or qualified retirement plans. Withdrawals from IRAs and qualified retirement plans are taxed as ordinary income regardless of the nature of the income or gain, so individual investors should talk with their tax and investment advisors before investing.
Some investors may have ignored the benefits of dividend paying stocks during the boom years of the equity markets. However, current circumstances warrant a closer look. Historically, dividend-paying stocks made a significant contribution to total return and reduced portfolio volatility during market dips. If, as is generally accepted, the economy is indeed experiencing a period of prolonged expansion, improving stock market performance and rising interest rates, then a better time to consider dividend- paying stocks may be hard to find.
Thomas Howard, CFP, is president of Trustmark Securities Inc. in Jackson. Contact him via e-mail at “firstname.lastname@example.org.