In the cold light of day, plenty of yesterday's come-hither growth stocks have been revealed as vainglorious floozies. But the stocks that have long held appeal as more conservative, chaste alternatives -- those that pay dividends -- are getting scarce. And companies that do pay dividends tend to offer stingier yields.

The combination of those trends is unwelcome news for investors, because dividends have traditionally helped bolster stock returns, and that's especially valuable in a laggardly stock market.

Though dividends have been a solace to investors in hard times before, companies today are invoking the economy as an excuse to cut their payouts. Standard & Poor's predicts the drop-off in dividend payouts this year will be the steepest since 1942, because so many cash-poor companies have been chopping dividends to save money. For the first six months of 2001, dividends on the S&P 500 index fell 7.1% from the year-earlier level.

Even before the downturn, companies had grown increasingly miserly with dividend payouts. Twenty years ago, the average yield of a dividend-paying member of the S&P 500 was 5.5%; today it's a meager 2.0%. That's not enough to punch up a stock's return by much.

Also, of course, fewer companies are paying dividends at all. Dividends have traditionally been the province of more mature companies, but the market in recent years has tilted toward younger, growth-oriented companies that prefer to reinvest profits in their business. According to one academic study, the proportion of companies that paid dividends peaked at 66.5% in 1978, then started dropping. By 1999, only 20.8% of firms paid dividends.

Even once-staid industries like telecommunications, which used to reliably crank out dividends for the widows-and-orphans crowd, have curbed or eliminated payouts. Pushed to be more competitive in the wake of deregulation, telecom outfits have channeled the money instead into projects for internal growth or acquisitions. Lately, in the face of sharply dropping revenues, these companies have gotten more tight-fisted with their dividends. This week Nortel said it would ax its dividend, joining Corning. Last year AT&T stunned investors when it announced it would cut dividends by three-quarters.

To a lesser extent, the same trend can be seen among regulated utilities, another traditional haunt of dividend investors. Instead of handing profits back to investors, they're more likely to invest some of the money in unregulated businesses with the potential for faster growth.

Of the remaining stocks that still boast high dividend yields, many hail from the REITs sector. Investors in REITs don't have to worry about having their dividends obliterated, because the structure of the companies dictates that they pay out 90% of their earnings as dividends.

But like any stocks, REITs can still suffer capital losses. In 1998, for example, the average REIT fund finished down about 15%, despite the dividend. And because REITs represent one narrow sector, investors shouldn't allocate more than about 10% of their portfolios to them.

REITS Dominate the Ranks of Companies
With Big Dividend Yields. *
Stock Dividend yield % Type of stock 3-Year %
Return Hospitality Properties (HPT - Get Report) 9.8 REIT 7.7
Amerigas Partners (APU) 9.5 Oil/gas 10.1
Health Care Property (HCP) 8.8 REIT 9.1
Franchise Finance Corp. (FFA) 8.7 REIT 7.0
Healthcare Realty Trust (HR) 8.6 REIT 9.5
Highwoods Properties (HIW) 8.6 REIT 2.4
Mack-Cali Realty (CLI) 8.5 REIT 2.0
Allied Capital (ALD) 8.3 Mortgages 11.0
Post Properties (PPS) 8.1 REIT 6.1
Plum Creek Timber (PCL) 8.3 Forestry and wood products 8.1
*Screen limited to domestic stocks with a market cap of at least $1 billion, with dividends yields and three-year total return greater than or equal to the S&P 500.
Source: Morningstar.

Glorious History: Dividends Boosted Returns Big-Time

Like the gradual disappearance of certain other relics of the past -- wide-brimmed hats, condors, fountain pens -- this ebbing of dividend yields is an occasion for regret. Despite their frowzy image, over time dividend-paying stocks have made lots more money for investors than stocks that don't pay out in this way.

Over the 50-year period ending in 2000, S&P 500 companies had annualized returns of 8.7% based on capital appreciation alone -- but if dividends were reinvested, returns leaped to 12.75%. "That's because back then, stocks did have enormous yields," says Howard Silverblatt, editor of quantitative services for Standard & Poor's. Compounded over time, dividends could give a tremendous lift to returns.

Though dividend-payers tend to be cast as slow-breathing, dullard investments, in the past they've been a boon to investors in risky companies. A study by finance professors Kathleen Fuller at the University of Georgia and Michael Goldstein at Babson College found that of the riskiest 10% of companies (measured by beta), those that paid dividends posted 100% higher returns than those that didn't.

Between 1970 and 2000, risky stocks that paid dividends returned an average of 1.4% a month, while those that did not returned only 0.7%.

But today it may be difficult for investors to apply those findings to their own portfolios, because riskier, growth-oriented companies are increasingly unlikely to pay worthwhile dividends. Most tech companies, for example, offer pretty meager dividend yields.

High-Return Big Tech Stocks
With the Biggest Dividend Yields*
Stock Dividend yield % 3-year return %
Diebold (DBC - Get Report) 2.0 4.1
Avnet (AVT - Get Report) 1.3 -7.5
Electronic Data Systems (EDS) 1.0 20.8
Pioneer-Standard Electron (PIOS) 0.9 8.7
Harris (HRS) 0.7 -7.9
AVX (AVX) 0.7 39.6
Sharp ADR (SHCAY) 0.7 16.1
Autodesk (ADSK) 0.6 5.5
IBM (IBM) 0.5 18.4
Linear Technology (LLTC)
0.3 39.8
*Screen of tech stocks with 1-year and 3- year returns greater than sector average and revenues greater than or equal to $500 million.

Today, Income-Seekers Look Elsewhere

The trend toward ever-lower yields may be impossible to reverse. Instead of handing money back to shareholders, managers today are ideologically inclined to funnel residual profits into buying back stock or making acquisitions.

One reason is that dividends aren't tax-efficient. They're taxed twice, when a company pays income tax and when shareholders do.

Another reason is that investors today approve of companies retaining the money, provided they have a profitable use for it. Throughout the '90s, that strategy made sense: As companies increasingly reinvested their profits, stock prices surged. Capital appreciation more than offset the dwindling value of dividends. "If I'm getting a 20% to 50% return on stocks every year, I don't care about dividends," says Silverblatt.

Even now, though dividends are more valuable in a down market, investors don't seem to be clamoring for their return. "It's good for a company to have the cash flow and ability to pay dividends," says Steve Fossel, manager of the ( BEOOX) Berger Large-Cap Growth fund. "But if they choose to reinvest the money in other ways, that's probably even more positive than paying out the dividend. If a company has the opportunity to invest in high-return projects rather than pay money out to the shareholder, I think that's great."

Despite their historic contribution to high stock returns, dividend stocks have steadily lost favor with portfolio managers. In January, the large-cap growth fund Fossel manages underwent a name change; it was previously called a growth and income fund, which meant it had to have 65% of its holdings in dividend-producing stocks. The income tag "seemed like a constraint because the dividend yield on a lot of stocks was not high to begin with," he explains. Plus, it was hard to find dividend-generating growth stocks. "A deep value person might be more interested in dividends than a growth person would be," says Fossel.

As the supply of dividend stocks has dried up, other fund companies have opted to rechristen funds. MFS Equity Income metamorphosed into MFS Value, while Janus Equity Income will become Janus Core Equity at the end of July.

Financial advisers seem equally unhappy about current dividend offerings. "The yields overall are lower, and there's more volatility in the payment of dividends," explains Eric Bruck, a certified financial planner at Bruck & Caine Advisors in Culver City, Calif. Though he advised buying dividend stocks in the mid '80s until the early '90s, he hasn't done so since.

Dividend stocks might be appropriate for an income-seeking investor in a low tax bracket, says Herbert Daroff, a certified financial planner at Baystate Financial Planning in Boston, Mass. But wealthier investors should avoid dividend stocks, because the income they throw off generates taxes. Because dividends are taxed at the ordinary rate, shareholders in the top tax bracket could end up paying taxes at twice the rate they pay for long-term capital gains. "If you're in a high enough tax bracket, you may be better off with a muni bond than a dividend-paying stock," says Daroff.

And it doesn't make sense to hold dividend stocks in a tax-deferred retirement account, because they typically offer little in the way of growth.

"The bottom line is if you're an equity investor, it's very hard to come by a meaningful dividend yield in a mutual fund," says Kunal Kapoor, a senior analyst at Morningstar. He recommends that investors seeking income look to bonds instead, perhaps investing in a hybrid mutual fund that includes both stocks and bonds.

As originally published, this story contained an error. Please see Corrections and Clarifications.