Dividend Hunt May Backfire on Investors
When it comes to stock dividends, bigger may not always be better.
That’s a warning investors ought to heed as they mull over the effects of the dividend tax cut Congress approved last week, financial pros say.
The maximum federal tax rate on dividend income will drop to 15% from what had been 30% or higher for many investors. The new rate will be the lowest levied on dividends since before World War II.
The rate cut is expected to make dividend income far more appealing to investors. With yields on money market funds and high-quality bonds at generational lows -- and that interest still taxed at regular rates as high as 35% -- many investors may be tempted by annualized dividend yields that top 3% on many common stocks, and in some cases exceed 6%.
But investors who focus exclusively on the highest-yielding stocks may be buying shares whose dividends are in jeopardy, experts say. A high yield can be a warning that the market expects the company to cut its payout.
Also, investors who reach for high current income on common stocks may be giving up heftier returns over time by missing companies that pay less now but are likely to raise their dividends on a regular basis.
Because the top tax rate on long-term capital gains also has been reduced -- to 15% from 20% -- some money managers say the stocks that could be helped the most by the tax changes are those that have good prospects for growth as well as income.
“Growth-and-income stocks benefit from a double whammy,” said Steve Colton, manager of the Phoenix-Oakhurst Growth & Income fund in Scotts Valley, Calif. “The capital gains rate goes down, so the appreciation is taxed at a lower rate, and of course, the dividends are taxed at a much lower rate.”
One example he likes is Citigroup Inc. The financial giant’s stock price is up 11% so far this year, to $39.09 on Friday.
As for dividends, Citigroup’s annual payment per share is 80 cents, giving the stock a yield of 2% -- which is above the 1.8% average yield of the blue-chip Standard & Poor’s 500 stocks. (The yield is calculated by dividing the dividend by the stock price.)
Citigroup has raised its dividend every year for the last five years. The payment was lifted 11% in the first quarter, to a quarterly rate of 20 cents.
An investor who paid $24 for Citigroup stock at the end of 1998 is earning a yield of 3.3% on those shares, based on the current dividend. That illustrates one of the key benefits of rising dividends, money managers say: Unlike with a fixed-rate bond, a stock’s dividend yield can increase over time.
“This is the first chance to invest in a growing stream of 15%-taxed income,” said Joe Keating, chief investment officer of AmSouth Bancorp in Birmingham, Ala. “That’s very positive for investors.”
Many portfolio managers say a company with a dividend yield in the range of 2% to 5%, and with healthy growth prospects, may be a better choice than much higher-yielding stocks.
“We never stretch for yields,” said George Mairs, manager of the Mairs & Power Growth fund in St. Paul, Minn. “When companies pay really high dividends you don’t get much earnings growth. Still, we kind of feel like we’re entitled to at least a 2% annual yield, which can add a lot to the total return over time.”
Chris Wiles, co-manager of the Strong Large Company Growth fund in Milwaukee, concurs, noting that high-dividend payers can be risky.
“My experience over the years has been that you’re better off chasing dividend growth rather than dividend yield,” Wiles said.
Many investors are “intrigued” by Altria Group Inc.’s dividend yield of 6.1%, he said, referring to the tobacco firm formerly called Philip Morris. “But you have to ask yourself how stable that dividend is. It might be just a matter of time before some state or some court says, ‘If you’ve got enough money to pay your shareholders a 6% dividend, you can afford to pay more legal damages.’ ”
Over the last decade, investors in many electric utilities have learned the hard way that big dividend payments often are at risk of being cut if a company gets into financial trouble.
Colton said a modest “payout ratio” -- the percentage of per-share earnings paid out in dividends -- can point to a company that will be able to raise its dividend in the future if financial performance is strong.
Citigroup, for example, is expected to earn about $3.22 a share this year, according to Thomson First Call. With a dividend of 80 cents a share, the company is paying out 25% of its profit as dividends.
By comparison, some utilities pay out three-quarters or more of annual profit in dividends, which may leave little room for significant increases. The average blue-chip stock’s payout ratio was about 30% of operating profit last year, according to S&P.;
Still, there are utility companies that offer above-average yields and high dividend “quality,” S&P; said. Its list of highly rated stocks includes such names as Progress Energy Inc. of Raleigh, N.C., which yields 4.8%; and Black Hills Corp. of Rapid City, S.D., which yields 4%.
Shares of many small and mid-sized banks also have good reputations for dividend growth, according to S&P.;
Mairs said he has been adding recently to his stakes in 3M Co. and General Mills Inc., two stocks whose profit, and dividends, can increase steadily, he believes.
3M stock yields 2.1% at Friday’s closing price; General Mills’ yield is 2.4%. Prices of both stocks are nearly flat for the year to date, while the S&P; 500 index is up 6.1%.
“When the market is up 6% and a good company is flat, I’m inclined to think it’s a good buy,” Mairs said.
Wiles said big technology names including Microsoft Corp., Intel Corp. and IBM Corp. might be in a position to increase their dividends in the future, so they could be decent investments even though their yields are minuscule now. “They have tons of cash and don’t know what to do with it,” he said.
Microsoft paid its first-ever dividend in the first quarter. Another tech giant, wireless firm Qualcomm Inc., also surprised investors in the first quarter by declaring a dividend.
Dell Computer Corp. might be a candidate to begin paying a dividend, Wiles added, noting that Chief Executive Michael Dell has indicated the company would consider such a move if tax laws were changed.
Though Wiles remains worried about the health of the U.S. economy, he said there are a number of leading blue-chip firms that offer long-term dividend growth, making them attractive in a stock market that may struggle to generate decent capital gains.
Names he likes include energy titan Exxon Mobil Corp., which has a 2.8% yield; and Johnson & Johnson and Pfizer Inc. in the drug sector, which have histories of being “good dividend citizens.” J&J;’s yield is 1.8%; Pfizer’s is 1.9%.
Money managers say one of the key benefits of the tax rate cut is that it may encourage companies to think carefully about spending profit on such things as share buybacks, acquisitions and risky growth initiatives instead of paying bigger dividends to shareholders.
“We think a company only should be buying back its stock when it’s truly cheap,” said Don Peters, manager of the T. Rowe Price Tax-Efficient Growth fund in Baltimore. “A stable, steady dividend policy is a good way to run a business.”
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Above-average yields -- and quality
These companies have stock dividend yields well above the blue-chip average. What’s more, all have increased their dividends in recent years, and all are rated highly for earnings and dividend quality by Standard & Poor’s.
*--* Ticker Friday Annual Div Stock symbol price dividend yield* Federal Signal FSS $16.61 $0.80 4.8% Progress Energy PGN 46.86 2.24 4.8ETD KeyCorp KEY 25.85 1.22 4.7 FirstMerit FMER 21.32 1.00 4.7 Allete ALE 24.70 1.13 4.6 RPM RPM 11.80 0.52 4.4 Piedmont Natural Gas PNY 39.01 1.66 4.3 Black Hills BKH 30.12 1.20 4.0 Washington Federal WFSL 22.40 0.84 3.8 Provident Bankshares PBKS 24.34 0.92 3.8 S&P; 500 index 933.22 16.43 1.8
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*Dividend yield is the dividend divided by the stock price.
Sources: Standard & Poor’s, Bloomberg News
