Investors looking for income are increasingly hard pressed to find an inflation-beating yield matched with reasonable levels of risk. However, according to Forbes magazine and a report cited from Ibbotson Associates in November 2004, we can learn from history that dividend income has accounted for well over half of the long-term real return on big company stocks, during the past 75 years.
And yet, despite dividends historical success and recent tax benefits, many investors still pay little attention to stocks offering dividends. This could be a mistake.
There is a simple case to be made for considering dividend-paying stock in a balanced portfolio: with stocks that essentially pay you to own them via dividends, you don’t have to depend solely on the stock’s gains or a strong market to make money. Furthermore, stocks with solid dividend prospects don’t go down as much as other stocks, because when they start fading, the resulting rise in dividend yield often attracts more buyers.
Another reason to consider stocks that pay dividends is that the maximum federal tax rate on most dividends is currently 15% (5% for taxpayers in the 10% and 15% marginal tax brackets) and this rate isn’t scheduled to expire until after December 31, 2008. Prior to 2003, dividend income was taxed as ordinary income, with rates running as high as 38.6% in 2002. Be aware, however, that some types of dividend income are not included in these new rules.
In most cases, dividends received from a Real Estate Investment Trust may not be subject to the new tax rates. Ultimately, for a taxpayer in the top federal tax bracket of 35%, a 3% dividend yield taxed at 15% is almost equivalent to a 4% yield on a taxable bond.
Successful dividend investing
Your objective is to look for stocks with minimal risk of dividend cuts and/or other negative events, and a high probability that the dividends will increase while you own the stock. When the dividend increases, the yield on your initial investment goes up with the dividend. Furthermore, the dividend increase often propels the share price even higher.
When choosing your investments, be sure to consider the following:
• Look for stocks with more than 3% dividend yield. However, while a higher yield is better, don’t be a yield-chaser dismissing other important details and considerations such as security and longevity.
• Choose well and let it ride. One of the most powerful yet least appreciated aspects of dividend investing is the fact that the best dividend payers tend to increase their dividends year in and year out. When you couple that with the fact that your cost basis for a given investment typically stays the same, you’ve discovered the catalyst behind the growing dividend yield.
• Stick with low-debt companies. Cash-strapped companies may view dividend payouts as a luxury. The financial leverage ratio, which is total assets divided by shareholders’ equity in the company, is a starting debt measurement. A leverage ratio of 1.0 means that the company has no debt — the higher the ratio the more the debt.
• Pay attention to earnings growth. Know whether a company’s future earnings are headed up or down. Since dividends ultimately come from earnings, dividends can’t grow if earnings don’t. Analysts’ long-term average annual earnings growth forecasts are a good resource for this information.
• Consider stock funds that invest in dividend-paying stocks. If you are looking for lower risk growth, they preferably should not invest in REIT’s because of the unpredictable nature of their dividend distributions. Look for companies included in the index if it has been paying dividends for five years and has a high payout ratio (dividends in relation to earnings.)
• Get help. See the assistance of a qualified financial advisor who can not only help you research and chose the right dividend paying stocks for you but also integrate your plans in well-balanced portfolio.
Gary N. Garner is a financial advisor with American Express Financial Advisors in Hattiesburg. This information is provided for informational purposes only. The information is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor. The views expressed may not be suitable for every situation. American Express Financial Advisors Inc. Member NASD. American Express Company is separate from American Express Financial Advisors Inc. and is not a broker-dealer.