When Congress cut the tax rate on dividends to 15 percent last year, American investors got a bigger boost than most of them seem to realize.
If you own $10,000 worth of stock with an average dividend yield of 3 percent, you can now put $255 in your pocket after federal taxes. Before the 2003 changes, if you were in the highest tax bracket, you could have pocketed only $184.
But that’s just half the story. The rate cut has helped change corporate behavior. Businesses that once hoarded cash are now distributing it to their shareholders. Most investors haven’t noticed, but there has lately been an orgy of dividend increases, unprecedented in recent history.
A week ago, for example, Wal-Mart Stores (WMT), the world’s largest retailer, hiked its quarterly dividend by 44 percent. Last month, HCA Inc. (HCA), the nation’s largest hospital operator, increased its annual dividend from 8 cents to 52 cents. Wendy’s International (WEN) doubled its quarterly payout. Earlier, McDonald’s Corp. (MCD) increased its dividend by 70 percent and Citigroup Inc. (C) by 94 percent.
Last year, 19 of the companies that constitute the benchmark Standard & Poor’s 500-stock index started paying dividends for the first time, including Microsoft (MSFT), the world’s second-largest company by market capitalization. The number one market-cap firm, General Electric (GE), raised its dividend in December for the 28th consecutive year.
Total dividends paid by the S&P companies have risen an average of 15 percent over the past 12 months, according to statistics in Barron’s; for the 30 companies of the Dow Jones industrial average, the increase has been 10 percent.
By historic standards, however, the overall yields of U.S. stocks are low. A stock’s yield is its dividend payout (usually defined as the expected quarterly payments for the year ahead) divided by its current price. Based on its new quarterly dividend of 13 cents, Wal-Mart, for instance, will pay out a total of 52 cents per share over the next 12 months. The stock a week ago closed at $60.60, so the yield is 0.9 percent (0.52 divided by 60.60).
The average S&P 500 stock at the end of February yielded 1.6 percent. That compares with yields averaging more than 4 percent as recently as the 1980s. Yields then began to drop sharply, from 3.8 percent in 1991 to 2.8 percent in 1994 to 2.1 percent in 1997 to 1.1 percent in 2000.
Part of the decline came simply from the big rise in stock prices. Don’t forget that price is the denominator of the yield calculation. If the price moves up faster than the annual payout, then the yield will fall. But there were other reasons for the drop as well.
First, investors didn’t care much about dividends; they were transfixed by capital appreciation, or rising prices. Second, academic research and simple observation were telling corporate managers that, because profits distributed as dividends were doubly taxed (both at the corporate and personal levels), investors would just as soon forgo them. Let the company keep the cash and reinvest it in the business — or buy back its own shares, thus raising the value of each remaining share.
Share buybacks, which became highly popular in the 1990s, turned profits that would have been taxed at the ordinary-income rate (then as high as 39.6 percent) into profits that would be taxed at the capital gains rate (a maximum of 20 percent).
Companies were happy to pile up the cash, which could be used for acquisitions or to buy pieces of other companies or to generate decent returns in the bond market.
Today, the picture has changed. Both the capital gains rate and the dividend rate are capped at 15 percent, and bond yields are low. In addition, the corporate scandals that began breaking in late 2001 have encouraged companies to make their earnings more visible — to prove to investors that they are really making money, not merely moving numbers around on the books. Dividends are the best evidence of a healthy business. You can’t fake a dividend; it’s hard cash.
There’s a final reason that companies are increasing their dividends lately: They’re making higher profits. In the fourth quarter, Business Week points out, “earnings from continuing operations at S&P 500 companies . . . leaped 28 percent, compared with the year-earlier period.” And companies seem confident that the strong profits will continue — otherwise, firms would be reluctant to raise dividends at double-digit rates. While investors can tolerate a decline in earnings (businesses are always ready with an excuse), they exact a severe penalty on practically any company that cuts its dividend.
The yield on the S&P, at 1.6 percent, and the yield on the Dow, at 2 percent, aren’t really paltry compared with the alternatives. Late last week, money-market funds were yielding 0.5 percent on average; two-year Treasury notes, 1.7 percent; five-year T-notes, 3 percent. And the federal tax on Treasury and corporate-bond interest payments is the full ordinary-income rate — up to 35 percent, compared with 15 percent for dividends.
Or look at municipal bonds. Yes, they pay interest free of federal taxes, but the yield on a typical five-year AAA-rate muni was only 1.9 percent last week. For an investor in a 25 percent bracket, the after-tax yield on General Electric dividends is 1.8 percent.
Let’s say that you invest $10,000 in a five-year muni and $10,000 in GE stock. This year, after federal taxes, you’ll put about $190 in your pocket from the muni interest and $180 from the GE dividends. But five years from now, the muni will still be paying you $190 while the GE stock — assuming the dividend rises at 8 percent annually (a modest rate for the company) — will pay you $264. And that doesn’t even include the likely rise in GE’s stock price.
The stocks of the Dow, of which GE is a component, offer particularly attractive dividend opportunities. You can buy the whole index in a package, as an exchange-traded fund (ETF) nicknamed Diamonds (DIA).
But consider individual Dow stocks. At the end of February, eight of them were yielding at least 3 percent, including Altria Group (MO), maker of tobacco and food products, at 4.7 percent, and J.P. Morgan Chase & Co. (JPM), the money-center bank, at 3.3 percent; and 13 were yielding at least 2 percent, including International Paper Co. (IP), 2.3 percent, and Coca-Cola Co. (KO), 2 percent.
About a decade ago, a strategy of investing in Dow stocks with the highest dividend yields enjoyed a vogue. The “Dogs of the Dow” strategy fell on hard times during the go-go years of the late 1990s, when investors preferred flashy growth stocks over plodding dividend-payers. But Dogs of the Dow remains a good way to own solid, high-yielding companies for the long run. First Trust Portfolios offers a unit-investment trust — that is, a set portfolio, sold through brokerage firms — called Dow Target 10 Strategy, which owns the 10 highest-yielding Dow stocks. Returns on the UIT, back-tested through 1972, have averaged 13.3 percent annually (subtracting sales fees and expenses), compared with 12 percent for the Dow as a whole.
I am particularly drawn, however, to two securities that investors can buy as if they were individual stocks. The first is an ETF called iShares Dow Jones Select Dividend Index Fund (DVY), which began trading on the New York Stock Exchange last year. The ETF follows an index that screens a broad universe of stocks for high yield.
Among the top-10 holdings are Bank of America (BAC), currently yielding 3.9 percent; General Motors Corp. (GM), 4.2 percent; DTE Energy Co. (DTE), electric utility, 5.1 percent; and Comerica Inc. (CMA), a Detroit-based bank, 3.6 percent. Overall, the fund is yielding 3.2 percent — far more than a five-year T-note after taxes. Be aware, though, that the fund does not purport to be a balanced portfolio. It is heavily weighted toward banks (39 percent of holdings) and utilities (19 percent).
The second is First Trust Value Line Dividend (FVD), a closed-end fund that trades on the American Stock Exchange. This portfolio includes about 200 stocks, each rated “1″ or “2″ for safety by the Value Line Investment Survey and paying relatively high dividends. The safety element is key. Often a high dividend yield indicates a company in trouble — in fact, a company on the verge of cutting its dividend. But high Value Line safety ratings, while not foolproof, offer good protection.
Holdings of the fund are more diversified than the iShares offering. They include such non-banks and non-utilities as Abbott Laboratories (ABT), drugs, currently yielding 2.4 percent; General Mills Inc. (GIS), packaged food products, 2.3 percent; Pitney Bowes Inc. (PBI), mail management, 2.9 percent; and Ashland Inc. (ASH), chemicals and petroleum products, 2.2 percent.
One advantage of First Trust Value Line Dividend is that, as a closed-end fund, it is trading at a discount of about 10 percent to the value of the stocks it owns — if they were sold today in the market. But discounts can be as much of a curse as a blessing; since no one can tell whether they will widen, they add risk to your investment. The iShares security, as an ETF, sticks close to the net asset value (that is, value in the stock market) of its holdings.
The iShares fund charges annual expenses of about 0.4 percent; the First Trust Fund, 0.9 percent. In both cases, of course, you have to purchase shares through a brokerage firm, so consider commission costs, too. Neither fund has a track record long enough to make solid judgments about its prospects, but there are so few good dividend-oriented portfolios that you don’t have much choice.
A conventional mutual fund that I highlighted last fall as the best of the bunch is T. Rowe Price Dividend Growth (PRDGX). Its manager, Tom Huber, searches for companies that are aggressively raising their dividends. His top holdings include Citigroup, yielding 3.2 percent; Altria Group; and GE. But Huber also owns First Data (FDC), yielding a mere 0.2 percent, and Microsoft, 0.6 percent. In fact, the fund as a whole yields only 1.1 percent. The bias is toward companies that have rising dividends rather than big dividends.
In today’s environment, I want to own stocks that have both characteristics. So far, with few exceptions, the mutual fund companies haven’t caught on, so you’ll have to do much of the stock-picking yourself.
It’s my strong suspicion that investors don’t yet realize the delicious tax benefits of owning stocks that pay good dividends. As they wake up, they will get hungrier and hungrier for such companies, whose shares may then rise at a higher rate than the market as a whole. That’s just a hunch, but, with the new tax treatment, it’s hard to see how you can lose even if I’m wrong.
– James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . Of the stocks mentioned in this article, Glassman owns GE and Microsoft. This article originally appeared in the Washington Post.