A Need for Stability Gives Dividends Renewed Luster

When it comes to dividends on stocks, the market’s motto has evolved since 2000 from “cash is trash” to “show me the money.”

With every major market index deep in the red year-to-date, stocks that pay dividends have come back into vogue--not only for the modest cushion provided by steady cash income, but also for the conservative, old-fashioned image these companies portray in a back-to-basics environment.

The income that dividends provide has helped bolster relative performance at conservative equity funds this year such as Fidelity Growth & Income, Vanguard Windsor II and Mairs & Power Growth, which are down 22.4%, 21.3% and 14.8%, respectively--in each case better than the funds’ category averages.

Still, while dividend income may be getting trendy once again with individual stocks, it probably isn’t a major focus for investors who are evaluating their current equity funds or looking for new ones, analysts say.

And fund companies primarily market other sorts of products, including bond funds and real estate-oriented funds, to investors who are specifically seeking a regular income stream. Most fund companies don’t play up a general stock fund’s dividend returns.

As for investors, there are several reasons dividend-paying stock funds haven’t attracted more attention, analysts say.

By the time the Standard & Poor’s 500 index had recorded five straight years of gains in excess of 20% during the market surge of 1995-99, cash dividends had become an afterthought for many investors. Earning a 2% to 4% annual yield from dividends in that environment seemed almost irrelevant.

“When market returns are high no one cares about dividends,” said Phil Edwards, chief fund analyst at Standard & Poor’s in New York.

Likewise, in a deep bear market, dividends’ relative importance in diversified funds also is, well, relative. For many investors, the pain of loss isn’t much different if a fund is down 20% because there is no dividend buffer, versus a loss of 18% with that buffer.

Many fund investors also dislike the tax implications of dividend income. Most fund owners choose to automatically reinvest, in more fund shares, any dividends their funds pay. So they don’t get a check--but they owe taxes nonetheless, unless their fund is held in a tax-deferred retirement account.

“You have to pay taxes on dividend income, and when the overall market is down the investor isn’t at all happy about that,” Edwards said.

Those looking specifically for a current income stream and willing to accept the tax bite are likely to focus on real estate funds, government bond funds or others that offer greater income than the typical dividend-paying stock fund, experts say.

“I don’t think you can really look to equity funds for income. It’s not like the old days, when a lot of stocks were paying 6%” dividends, said Sheldon Jacobs, editor of No-Load Fund Investor newsletter in Ardsley, N.Y.

“Even if there’s a 2% annual yield on a fund, the price fluctuations are going to overwhelm whatever the income may be,” he said. Also, investors who want quarterly income checks from their stock funds need to choose carefully: Some funds pay out dividends just once a year.

George Mairs, longtime manager of Mairs & Power Growth, based in St. Paul, Minn., notes that before the modern era of growth-stock investing that began in the 1960s, typically half or more of the average annual returns on stocks came from cash dividends (the rest was price appreciation).

Equities often offered a bigger income stream than bonds before the 1960s, he said.

“We’ll probably never get back to that situation, but the attitude toward dividends is changing, and hopefully significantly,” Mairs said.

The S&P; 500’s dividend yield, which bottomed at 1.1% in March 2000 at the end of the bull market, has risen gradually since then, said Arnold Kaufman, editor of S&P; Outlook, a newsletter for investors. But the current 1.9% yield is far shy of the index’s 4.2% average since 1926 and the 3.8% average since 1945.

Nonetheless, Kaufman said he is sensing “a turning point for dividends.” Among the 7,500 stocks that S&P; tracks, 299 raised their dividends in the third quarter as the market sank, up from 226 in the same period a year earlier.

“Dividend-paying stocks have been outperforming the non-dividend payers. They’re something of a safe harbor in a bear market,” Kaufman said. “Companies that pay dividends tend to be more conservative, and investors are more interested in conservative companies right now.”

Of course, not even a high dividend yield can fully protect a stock if the company’s fundamentals weaken. Philip Morris Cos. stock, a favorite of many value-style investors, has plunged from $51 in mid-August to under $37, after the company warned of slowing earnings growth and amid more jury verdicts against tobacco firms in cigarette-liability cases.

Morris’ annualized dividend yield has risen from 5% in mid-August to 7% as the share price has tumbled, but that may be little consolation to investors who bought at $51 and have lost 28% of their capital, on paper.

Still, Mairs said he hopes investors continue to perceive value in cash dividend income.

“What shareholders should do is go to the annual meetings and suggest that the dividends be raised,” Mairs said. “Hopefully everybody will start clapping and something will happen.”

One argument for managements to return more profit directly to shareholders via dividends is that many of the big corporate mergers of the 1990s have been disasters. Also, companies’ use of cash to repurchase their own shares has run into the same trouble many individual investors have faced: share prices just keep falling.

These factors could contribute to a renewed appreciation for higher dividend payments, analysts say.

Edwards said stock funds that long had been known as equity-income funds “were dying in the late 1990s, but what saved them was the downturn in the market,” bringing so-called value investing back into style. One of the hallmarks of value stocks is an above-average dividend yield.

Vanguard Windsor II, for example, is among the “steady-Eddie type of funds” that have provided solid long-term returns and also avoided the worst of the bear market thanks to its value approach, Edwards said.

It’s no stampede, but income-paying funds are one of the few categories tracked by Lipper Inc. that have reaped cash inflows from investors in recent months, said Don Cassidy, senior analyst with Lipper Inc. in Denver.

“Clearly there is a preference for the conservative these days,” Cassidy said. “The investing world is upside down from where it was three years ago.... The psychology has changed because people are not buying on hope anymore.”

Mairs, who has been with Mairs & Power since 1952 and has run the fund since 1980, said he long has favored stocks that pay dividends. “Their presence provides stability” in a portfolio, he said.

One of Mairs & Power Growth’s biggest holdings and best-performing stocks this year is Wells Fargo & Co. The bank has a tradition of raising dividends every nine months. The stock was up 10.8% in the first three quarters. Its annualized dividend yield is about 2.5% at the current share price.

Two holdings Mairs and co-manager William Frels have added to the portfolio this year are General Electric Co. and Merck & Co. The classic growth stocks, which got cheap enough for Mairs’ taste this year, now sport yields of 3% and 3.2%, respectively.

Those aren’t the 6% dividend yields that some market veterans fondly remember, but they’re a buffer against share price declines, Mairs said.

Moreover, if predictions of single-digit annual average gains on stocks hold true in coming years as the market struggles to recover, even 2% or 3% dividend yields could make a big difference in overall returns.