Rising stock dividends regain allure as investment strategy

Trying to overcome Americans’ deep distrust of the stock market, Wall Street has latched on to an investing concept from a bygone era: Buy equities and get cash back every quarter, potentially for as long as you own the shares.

The come-on is for the dividends that many companies have regularly paid to their shareholders. For much of the last century, dividends were the primary reason to own stocks. The chance of capital appreciation was secondary.

As share prices rocketed in the wild bull market of the 1980s and 1990s, dividends became an afterthought.

No more. With tens of millions of people — particularly retiring baby boomers — looking for investment income and fed up with dismally low interest rates on bank accounts and bonds, brokerages and money managers believe there’s a huge and growing audience for the dividend pitch.

Investment strategists at major firms such as BlackRock Inc., Pimco and Wells Fargo Securities have been tripping over one another to highlight dividends’ appeal for the last year. Newport Beach-based Pimco, best known for its bond portfolios, in December launched two dividend-focused stock mutual funds.

Big-name companies including Amgen Inc., Starbucks Corp., Walt Disney Co. and Microsoft Corp. also helped stoke investors’ interest in 2011. Each raised their cash payouts to shareholders by 25% or more.

The dividend story could soon get another big boost: Apple Inc., which has long hoarded the cash generated by its phenomenally successful products, is under pressure to spread some of that wealth by reinstating a payout. The company hasn’t paid a dividend since 1995.

Apple management is thinking “very deeply” about what to do with the firm’s $100 billion in cash, Chief Executive Tim Cook told shareholders at the annual meeting last week.

Flush with earnings from the recovering economy, big-name companies in the Standard & Poor’s 500 index are expected to pay total dividends of $263 billion this year, up 9.1% from 2011 and surpassing the previous record of $248 billion in 2008, said Howard Silverblatt, senior index analyst at S&P in New York.

Some veteran small investors don’t need convincing about dividends’ allure. Jim Peoples, a 67-year-old retiree in Agoura Hills, says he has become more conscious of the benefits of those cash payments over the last decade, as bond and bank-account interest rates have plummeted.

His portfolio includes stocks such as AT&T Corp., Philip Morris International Inc. and Caterpillar Inc., all three of which have histories of regular dividend increases.

Five years ago, 300 shares of Caterpillar paid annual dividends of $360. Now those same shares pay dividends of $552, a 53% increase.

That’s a big advantage over the bonds in his portfolio, Peoples says, because bond interest payments stay the same for the life of the security.

If investors are relying solely on fixed-rate bonds, he says, “You’re not going to have purchasing power. The spending value of that money is really going to go down” after inflation.

What’s more, at least for now dividends get a tax break. They are federally taxed at a maximum rate of 15%. Bond and bank interest is taxed at ordinary rates, up to 35%.

Still, Wall Street knows it has an uphill battle persuading many investors to come back to stocks after two devastating market crashes in the last decade.

With current annual dividend payments on many blue-chip stocks equivalent to a “yield” of 2% to 4% on the price of the shares, that’s attractive compared with interest on bonds and bank savings. A 10-year U.S. Treasury note pays an annual yield of just 1.98%.

But shareholders always face the risk of a stock losing value. In another market downdraft it would be easy for a drop in a company’s share price to totally offset annual dividend earnings in a matter of minutes.

By definition, investing for dividend income requires a buy-and-hold strategy — exactly the approach that became discredited in the last decade as much of the stock market has flat-lined.

To get the full benefit of rising dividends, “You have to truly make a long-term commitment of capital” to stocks, said Josh Peters, dividend strategist at investment research firm Morningstar Inc. in Chicago.

That’s a tough sell for plenty of skittish investors, and for their advisors.

Eric Bruck, a principal at financial advisory firm Silver Oak Wealth Advisors in Los Angeles, has favored the relative safety of bonds for his clients since the 2008-09 stock market plunge.

Yet as market interest rates have fallen, “We have to use a fine-tooth comb to find bonds we want to buy today,” Bruck said.

In the last few months the firm has moved a small portion of the average client’s portfolio into dividend-paying blue-chip stocks, such as Johnson & Johnson and Colgate-Palmolive Co., via mutual funds that focus on those issues, Bruck said.

But he said he couldn’t imagine shifting most clients’ assets heavily toward stocks because of the risk of another episode of severe volatility.

After 2008, “I still can’t be comfortable investing the same old way, because the financial system has been damaged,” Bruck said. “It will take a long time to heal.”

Some Wall Street strategists say that’s exactly why dividend-paying stocks are particularly attractive now. Investors, they say, increasingly will want the “bird in the hand” of cash dividends to justify being in the equity market. That was the mind-set in the 1950s, coming out of the horrors of the Depression and World War II.

This time around, as the population ages “that’s a demographic trend that’s going to drive demand for dividends,” said Charles Carlson, a dividend-focused money manager and investment newsletter editor in Hammond, Ind.

It looked that way in 2011: While the S&P 500 index closed virtually unchanged for the year, many of the index’s best-performing stocks were those of companies with long track records of paying dividends.

Shares of retailer Genuine Parts Co., for example, jumped 19% last year. Exxon Mobil Corp. shares rose nearly 16% and Coca-Cola Co. stock was up 6%. All three are on S&P’s list of dividend “aristocrats” — 51 companies that have raised their dividends every year for at least 25 years.

McDonald’s Corp. has become one of dividend investors’ favorite stocks in recent years. The company has boosted its payout 87% since early 2008. Its stock has nearly doubled in the same period.

Blue-chip shares’ gains have made them pricier relative to underlying earnings. But the average S&P 500 stock’s price-to-earnings ratio is 13 based on estimated 2012 profit, according to S&P. That’s less than half what it was in the heady days of the late-1990s bull market.

Continued turbulence in the market could be an ally to financially solid, big-name companies, said Gina Martin Adams, an investment strategist at Wells Fargo Securities in New York. “It may take another wave of market volatility” to turn more investors toward dividend payers, she said.

Morningstar’s Peters sees the potential for a “virtuous cycle” for dividend-paying companies and their shareholders. If companies that are generous with dividends see their shares outperform the market, that could attract more investors to the stocks, while also encouraging the companies to remain dividend-friendly.

That would be a throwback to the post-World War II era, a time when fat dividends were Wall Street staples. Dividends accounted for 66% of the S&P 500 index’s overall return in the 1940s; stock price appreciation accounted for 34%.

Even in the 1950s, when stocks zoomed, reinvested dividends made up 29% of the S&P 500’s total return for the decade.

By contrast, in the 1990s dividends accounted for a mere 16% of the S&P return.

As stocks soared dividends became less important. Investors came to expect the thrill of fast capital gains.

Companies commonly have preferred to use their excess cash to buy back stock in the open market instead of raising dividends. Managements’ argument was — and still is — that buybacks helped to instantly bolster share prices.

But companies that bought back shares when they were overvalued at the bull market peak were engaging in the equivalent of throwing shareholders’ money down a rat hole. Investors who held on to the stocks arguably would have been better off if the companies had paid out the money in dividends.

Even now, “I think many companies will have to be dragged kicking and screaming” to part with their cash via higher dividends, Peters said. Corporate earnings may technically belong to shareholders, but executives often are reluctant to let go.

Some companies say there’s another reason they should be cautious about raising dividends: If the economy were to slump again, slashing corporate earnings, dividend payouts might have to be reduced as well. That would be a heavy blow to people who bought stocks specifically for that income.

As some investors have learned the hard way, there are no guarantees with dividends. Bank stocks had been among the most popular dividend issues until 2008 — when the financial system crashed and many banks slashed their payouts.

General Motors shareholders faced the worst fate of all: The auto giant suspended dividend payments in 2008 and one year later filed for bankruptcy protection, turning its shares worthless.

Because of the inherent risk, dividend-paying stocks are appropriate as just one element of an income-generating portfolio, financial advisors say.

Still, the surge in corporate earnings in recent years should be a comfort to dividend-hungry investors. It has given many firms the wherewithal to maintain or increase their payouts, if they choose.

One measure of dividend potential is the so-called payout ratio — the percentage of annual earnings paid to shareholders via dividends. That rate fluctuates with earnings cycles and with dividend amounts.

The estimated payout ratio for 2011 was just 30% for the S&P 500 companies, a record low percentage.

That doesn’t assure that the firms will be significantly more generous with dividends. But it does mean that if companies want to steer more cash directly to shareholders, “There’s plenty of room to do it,” Silverblatt said.

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