The Dividend Stock Advisor

Return to Article

Why Dividend Stocks Matter Now

David Peltier

The single largest misconception out there for individual investors is that it's not possible to generate consistent gains in changing market conditions by owning stocks. See, smaller investors don't have the time to follow the markets every day, and have a tendency to enter bull markets once they've peaked and sell out of bear markets right before they bottom out.

And once investors have been burned in a stock, they're going to be reluctant to jump back in with their hard-earned money. Even so, no investors ever made money by placing cash in their mattress.

That is why, after three straight years of negative returns from the S&P 500 index, we launched the Dividend Stock Advisor (formerly called the SaveSafe Plan) model portfolio in January 2003. The basket of stocks and municipal bond funds went on to generate a total return of 13.50% in 2003, when the major market averages rebounded significantly. But more importantly, the basket went on to gain another 13.64% in 2004, while the gains for the S&P 500, Dow Jones Industrial Average and Nasdaq Composite failed to crack the double digits. (The yield on a five-year CD, which could also be a useful benchmark for the aims of the model portfolio, is around 4%.)

As was the case two years ago, currently there aren't many worthwhile money-making opportunities for investors looking to generate steady income. Interest rates are so low that many cash money-market accounts are offering 1.5% returns, and the dollar has been weak to boot. Even corporate bonds appear played out, as the Federal Reserve will likely take interest rates higher than the current 2.50% before the rates move back lower. And the inverse nature of bond yields tells us that higher rates mean losses in principal.

But most folks are looking to gain a higher return on their investments than they would find in a CD or government note. So, where does that leave chastened investors? Well, even before President Bush officially signed his dividend tax cut in May 2003, smart investors had begun looking at conservative equity vehicles that offer a solid, consistent yield.

A Crucial Moment

It may be the new 15% tax rate, or a record level of cash sitting on balance sheets, but companies have shown an increased penchant to pay dividends. In 2004, there were 272 dividend boosts among S&P 500 members, compared with 247 in 2003. And the hits may keep coming in 2005, as a recent report by strategists at Lehman Brothers suggests that total cash payments should grow 30% in 2005, compared with just 8% improvement in earnings.

The benefit of dividends isn't a new concept, however: Howard Silverblatt, market equity analyst at Standard & Poor's, calculated in November that dividends accounted for 41% of the benchmark index's gains since 1926. Share buybacks also remain a popular, though less tax-advantaged way to return cash to investors. But another reason to prefer dividends is that the terms are well-defined, whereas funds to repurchase a company's stock are authorized to be disbursed at management's discretion, if even at all. Strategies put forth by the likes of Microsoft (MSFT Quote) and General Electric (GE Quote) combine a sizable dividend with a steady repurchase program and have been well-received.

So now that we know why folks should be interested in dividends, what makes one investment look more attractive than the next?

Not All Dividends Are Created Equal

In evaluating a dividend-paying stock, the absolute primary thought has to be the viability and sustainability of the dividend itself. Find a company at which neither rain, nor sleet nor dark of night will keep that courier from delivering a 3% payment to your account every year.

The clearest danger to a dividend is a lack of cash flow. When a company has weak cash flow, the dividend is among the first costs to be cut so the company can at least appear to be bolstering that key metric. And a dividend stock that stops paying its dividend is of little value to anyone's portfolio.

How do you find a "safe" dividend? Look for companies whose operating earnings and cash flow can cover their annual payments at least two times over. While it is possible to raise capital through debt or equity offerings to prop up dividends in the near term, most companies would not sustain this practice for more than a quarter or two.

It also helps to take a look at a company's dividend history. While it's never possible to predict the future from the past, some companies have exhibited a tendency to raise their payouts annually. It's also wise to seek out yields that are trending toward the higher end of historical ranges.

Now, this following advice will shock those that yearn for the go-go 1990s, but the analysis you need to employ on dividend stocks is not entirely earnings-centric. A lot of the same fundamental homework that goes into picking dividend stocks will still apply here, but you need to add a layer of fixed-income-like analysis.

Dividend-focused investors are less interested in each individual trade and more concerned about whether a negative or positive earnings outlook will cause a firm to change its payout policy. And the time frame is longer than that of many retail investors, who consider a long-term holding to be anything more than a couple of weeks. The minimum holding period for any of the stocks in a dividend portfolio should be one year.

Of course, dividend or not, investors want to avoid any company whose stock might fall to $30 from $50. But if the same stock fell to $45 without a change in the fundamentals, that wouldn't be so worrisome in the near term because the losses would be cushioned by the dividend.

Facts About Dividends

Here's a quick lesson on basic dividend concepts and terms for new investors or for those looking for a refresher.

First of all, dividends are generally paid on a quarterly basis and can be raised, cut or eliminated at each interval. Again, investors should be most interested in firms that consistently and steadily raise their payout.

If someone says a stock has a 3% dividend, this is known as the yield. The yield is the ratio of the annual payment to the current share price (annual dividends per share divided by current price per share), so the yield and stock price always move in opposite directions given a constant rate of payment. For example, in late September when Merck's (MRK Quote) stock price dropped to the low-$30s from around $45, the yield rose to 4.8% from 3.4%.

Another often-heard phrase and an important factor in dividend investing is the ex-dividend date. Investors need to buy a stock before this date to qualify for the dividend in that given period. Also, if a company pays out 20 cents a share every quarter, all other things being equal, the shares would likely open down about 20 cents lower on the ex-dividend date because buyers that day will not receive the income.

The one wrinkle in all of this is that the dividend itself is usually not paid out until two to four weeks after the ex-dividend date. Investors can sell shares any time on or after the ex-dividend date and still receive the payout, even though the stock is no longer in their account.

Of course, as I said earlier, dividend investors generally have a longer holding period than a couple of weeks, but this remains a salient point to remember when selling a dividend-paying stock.