Focus on Dividends Should Be on Growth

Investors’ renewed interest in dividends -- fueled by the Bush administration’s proposal to stop taxing those cash payments -- could have dangerous implications.

Investors who are hungry for generous returns might start shopping for stocks that have the juiciest dividend yields.

But that could prove a trap. For one thing, a high yield on a common stock -- say, 5% or more -- can indicate that the market doesn’t believe the dividend can be sustained.

In such cases, the yield may be going up only because the stock price is going down. (A stock’s yield is the annual dividend divided by the share price.)

“Companies with high yields either have low growth potential or something risky on their income statements or balance sheets,” warned Arnold Kaufman, editor of Standard & Poor’s Outlook investment newsletter and an expert on dividend trends.

What’s more, many experts maintain that the best investment strategy with dividend-paying stocks is to pick companies that have a strong likelihood of raising their payments each year. Often, those aren’t the issues with the highest current yields. Over time, however, the combination of rising dividends and share price appreciation can produce hefty returns.

Rising dividends became harder to find during the bull market as many companies either held on to excess cash or used it to buy back shares. Then the 2001 recession slammed corporate earnings, further crimping dividends.

The average cash dividend paid by stocks in the blue-chip S&P; 500 index declined in 2000 and 2001.

But the S&P; dividend began to grow again last year -- albeit at a modest 1% rate -- even before the Bush administration floated its no-tax idea.

Some analysts believe that many companies will be more inclined to raise dividends in the next few years even if the Bush plan is shot down, or watered down, in Congress.

“The proposal to eliminate tax on dividends is just one of many factors that should lead to higher dividend payouts,” said a recent report from brokerage UBS Warburg in New York.

Other factors pushing companies to boost dividends include institutional investors’ desire to impose more “financial discipline” on corporate managers and more individual investors’ need for regular income as they hit their senior years, the UBS report said.

Microsoft Corp. stunned many on Wall Street last week when it said it would begin paying its first dividend, at an annual rate of 16 cents a share.

For now, however, the average dividend yield on blue-chip stocks remains near historic lows, at about 1.8% for the S&P; 500 index. That yield is a function both of the surge in share prices over the last two decades and the slowdown in dividend growth in the 1990s.

So the Bush plan -- which the administration says is rooted in its desire to end “double taxation” of dividends, meaning at both the corporate income level and as income to shareholders -- would clearly make stock yields instantly more appealing.

For someone in a combined federal and state marginal tax bracket of about 40%, a 1.8% tax-free dividend yield would be equivalent to 3% taxable yield, such as on a bank CD.

In that same tax bracket, a 2.5% tax-free dividend yield would be equivalent to earning about 4.2% on a taxable investment.

Even if Congress balks at eliminating dividend taxation, many analysts believe the administration will manage to win some kind of tax concession. One idea would be to reduce the maximum tax on dividend income to 20%, making it equal with the capital gains tax.

Whatever happens with the tax issue, the sudden spotlight on dividends is giving more investors an education about the role such cash payments can play in enhancing a stock’s returns over time.

Investors whose companies share profit directly with them, via dividend checks, can count on some level of return whether the stock price is up or down, noted Charles Carlson, who edits the dividend-themed DRIP Investor newsletter in Hammond, Ind. Investors are free to spend that return, reinvest it in the company’s shares or invest it elsewhere.

But dividend payments aren’t guaranteed, as is interest income on a bank CD. It’s relatively rare for companies to cut their dividends, but it happens, and the result can be devastating for shareholders.

Case in point: Energy company TXU Corp. had been paying an annual dividend of $2.40 a share until October, when the firm said its weak financial situation necessitated an 80% cut in the dividend, to 50 cents.

The stock, which was at $40 before the dividend cut, was trading at $19.95 as of Friday.

The TXU case illustrates the potential peril in simply buying a high-yielding stock without investigating the company’s financial picture. With a $2.40-a-share dividend, TXU’s yield was 5.8% in early October. As some investors found out too late, it was high for a reason: The market was signaling that it didn’t believe the dividend would last.

One starting point for any investor looking at a stock for its dividend is the “payout ratio”: What percentage of per-share annual earnings is the firm already paying out via dividends? If the ratio is more than, say, 50%, that could limit the potential for future dividend growth.

When researching a stock, analysts advise comparing its yield and its payout ratio with those of its peers in the same industry. If one or both numbers are significantly higher, it could signal that the market is worried about the dividend.

At a minimum, an above-average yield usually is an indication that Wall Street believes a company is a slow grower. When a business faces modest growth prospects, it is expected to return more of its profit directly to shareholders.

Many financial advisors say the smartest strategy for dividend-hungry investors is to pick stocks based on their potential for long-term dividend growth rather than high current yield.

“If you’re a buy-and-hold investor, it’s dividend growth you should be focusing on,” Carlson said.

As a company raises its dividend over time, the yield on an investor’s original share purchase rises in tandem.

What’s more, many companies that increase their dividends consistently are able to do so because their basic business is growing at a decent pace -- which also raises the chances for stock price appreciation in the long run to complement the dividend growth.

Many of the companies that have been most reliable for dividend increases over the last decade have racked up strong “total returns” in that period, meaning the combination of dividend income and share price appreciation. They include such blue-chip names as brewer Anheuser-Busch Cos., Delaware-based banking firm Wilmington Trust Co. and health products company Johnson & Johnson.

There’s no guarantee they’ll be great picks for the next decade, but for many dividend seekers, companies like those offer a good launch point for the hunt.