Dividend Paying Stocks (NY Times)

June 3, 2011
Assessing the Value of Owning Dividend-Paying Stocks
By PAUL SULLIVAN

THE first security I was ever aware of was a dividend-paying stock, the AT&T shares that my grandfather, a retired postman, owned when I was little. Those shares along with some other dividend-paying stocks formed the foundation of his nest egg. By reinvesting his dividends, he was able to amass sizable savings for someone who probably never earned more than $20,000 a year.

So when I heard recently that some advisers were using dividend-paying stocks to coax people who still hold their money in cash or low-yielding bonds back into the equity markets, my ears perked up.

After all, dividend-paying stocks were largely ignored in the high-growth years for much of the past two decades. Companies that pay dividends, like Coca-Cola, McDonald’s, Caterpillar and Johnson & Johnson, are established corporations with none of the go-go appeal of a technology start-up.

On the other hand, the people running those start-ups often had (and still do have) a good portion of their compensation tied up in stock options. And those options become more attractive the higher the stock price goes, making growth much more important than returning any capital to investors through dividends.

And until President George W. Bush’s tax changes in 2003, dividends were taxed at ordinary income tax rates, not the lower capital gains rate.

“The way the tax code was written, it made companies go for capital gains over dividends,” said Jason Trennert, managing director at Strategas Research Partners. “It made people make imprudent decisions. Dividends remind executives four times a year that it’s not their company.”

Mr. Trennert said that many clients of Strategas, which has headquarters in New York, are reporting increased interest in dividend-paying stocks. That could produce a chicken and egg situation of companies increasing or initiating dividends if investors are asking for them. The advisers and analysts I spoke to who favored dividend-paying stocks as a crucial part of anyone’s portfolio were divided into two camps.

The first offered more sentimental reasons. Kenneth Kamen, president of Mercadien Asset Management in Hamilton, N.J., said he had a relative in his 80s who has held a handful of dividend-paying stocks since the 1970s. Until recently, he reinvested the dividends to buy more shares. But with the stocks now worth more than $1 million and with the average dividend yield of 4.5 percent, the relative stopped reinvesting the dividends and now receives $61,000 a year in income.

Mr. Kamen said his relative’s rationale back in the 1970s is still sound: if the company paid a dividend, it was probably sound. “He said, ‘We didn’t have access to all this information,’ ” Mr. Kamen said. “Dividend-paying stocks represented an interesting form of research for him. You can’t fake cash.”

The second group considers these stocks to be a counterweight to portfolios excessively weighted toward supersafe investments, since the performance of those investments is going to lag over time.

Catherine Avery, who runs an investment advisory company under her name in New Canaan, Conn., said she is telling her clients that 54 percent of the returns in stocks since 1928 have come from dividends. Ms. Avery also notes that companies like Johnson & Johnson and Emerson Electric have maintained unbroken streaks of increasing their dividends — 49 years in the case of Johnson & Johnson and 53 years for Emerson.

She said she has been making these points to encourage clients who have resisted investing in equities since the recession to buy stocks again. “They missed two big years in the markets,” she said. “Now we’re reaching out to people and telling them this is your dead last chance to get back into the market at attractive valuations.”

The reality, though, is most people own dividend-paying stocks even if they don’t think of them in those terms. At the end of 2010, 373 companies in the Standard & Poor’s 500-stock index paid dividends. That is nearly 75 percent of the companies in the index that most investors track.

What follows is a more detailed assessment of the pros and cons of owning dividend-paying stocks.

THE UPSIDES All things being equal, dividend-paying stocks have several advantages.

Devotees like to point to their stability over the long term. Haverford Trust, which manages $6.5 billion, has all $3.5 billion of its equity allocation in dividend-paying stocks, said Hank Smith, chief investment officer of Haverford, in Radnor, Pa.

If a client 30 years ago had put $1,000 each into Johnson & Johnson, Coca-Cola and Procter & Gamble and reinvested the dividends, the firm calculates that that $3,000 would be worth $223,982 today. But over that same period, $3,000 invested in the S.& P. 500 would now be worth $64,668, and that money in 30-year Treasury bonds would have grown to $89,399, according to S.& P. indexes.

These exercises are always eye-opening but selective. Enron, WorldCom and Lehman Brothers also paid dividends to shareholders, who have long since seen the value of their holdings go to zero.

Mr. Smith argued that for passive, long-term investors, which many people are, dividend-paying stocks offer more comfort. “If you’re buying a stock for its dividend yield, why should you care about the day-to-day fluctuation of the stock price as long as it’s paying its dividend?” he said. “Do bond investors worry about fluctuation day to day?”

While these stocks are going to lag behind any big rally, they are also going to fall more slowly. “During the bear market, in 2008, when the S.& P. was off 37 percent, we were off 25 percent,” Mr. Smith said.

These stocks also offer at least some sort of hedge against inflation. A typical high-quality corporate bond is going to pay the same yield today as it will in 10 years. That could be a problem if the rate of inflation increases since that would effectively erode the value of the fixed coupon.

With dividend-paying stocks, companies could raise prices and then increase the dividends to keep pace with inflation. “Dividends play a hybrid role that they didn’t in the past,” Mr. Kamen said. “You don’t get that in bonds.”

The tradeoff is a stock’s price could swing widely, whereas a high-quality bond would stay the course.

DOWNSIDES The two big risks come from how quickly the economy grows — and thus how much cash companies have to pay dividends — and what policy makers do with taxes.

When the extension to the Bush tax codes expires in 2012, dividends could again be taxed at the ordinary income tax rate. This is how they were taxed for much for the bull market of the 1980s and 1990s.

“It’s a concern of ours,” Ms. Avery said. But, she added, “we believe there is enough cash sitting on corporate balance sheets that they do have the ability to increase those dividends to make the end product more attractive to investors.”

There is third, short-term concern. Right now, low interest rates make dividends attractive. As interest rates rise, which they will eventually, dividend-paying stocks become less attractive because their yields are unlikely to keep pace with the yields from high-quality corporate debt.

Jeremy Zirin, chief United States equity strategist at UBS Wealth Management, which has headquarters in New York, said one way to measure this is to look at the relationship between average dividend yield and the yield on the 10-year Treasury note. Right now, the dividend yield is about 2 percent while the 10-year Treasury is paying 3.5 percent.

This means these dividends are about 65 percent of the yield of Treasuries. Historically, when that ratio dips below 50 percent, dividend-paying stocks become less attractive. “We have a ways to go,” Mr. Zirin said.

But of course, Mr. Kamen’s relative would say that a decrease in the price of a dividend-paying stock is not all bad: it means the reinvestment plan buys more shares. That was exactly what my grandfather did.