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Stock Dividends Make a Difference

Stock Dividends Make a Difference

by Dave Kansas
Monday, August 10, 2009

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As the stock market continues to recover, more investors are easing back into the market. While stocks have had a good run, they remain well off their record levels reached in 2007.

Given the carnage of the past two years, it's unsurprising that some people are hesitant to invest in the stock market. One strategy to consider when wading back in is to look at dividend-paying stocks. Such stocks, or mutual funds that focus on dividend-paying stocks, often called "equity income" funds, provide you with an income (the dividend) while giving you a chance to benefit from capital appreciation of the stock.

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Beyond the dividend income, there are several reasons for investing in dividend-paying stocks. One, companies that can maintain or even increase their dividend payouts in the current environment are proving their strength. Also, in the wake of various accounting scandals, a steady dividend is proof that a company is actually making the money it says it is making. While accountants can fudge lots of numbers in a quarterly financial statement, they can't conjure up the cash required to make dividend payments.

Blue Chips Keep Paying

Despite the brutal economic downturn, a number of blue-chip companies, such as General Mills, Colgate-Palmolive and Lockheed Martin, have managed to maintain or even increase their dividends.

Also, bond yields remain at very low levels, making dividend yields competitive on a historical basis. Given the frailty of the U.S. economy, most economists expect bond yields to remain low for quite some time.

Brian Belski, market strategist at Oppenheimer, also thinks that with bond yields likely staying low for some time, retiring baby boomers may decide to focus on dividend-paying stocks to sustain their income.

Under current tax law, most dividend income is taxed at a maximum rate of 15%, while interest income from bonds is taxed as regular income. Another advantage for dividends: They tend to rise over time, while interest payments from bonds remain fixed for the duration of the bond.

Investing in dividend-paying stocks means looking for a stock that pays a good yield. The yield is calculated by dividing the annual dividend by the share price. Thus, manufacturer 3M pays an annual dividend of $2.04 and its share price is about $72, giving it a yield of around 2.8%.

In looking for good dividend picks, using the dividend yield of a major average is a good starting point. The Dow Jones Industrial Average has a dividend yield just above 3%; the Dow Jones Utility Average's yield is nearly 4.5%. That would make 3M a slightly below-average dividend-paying stock. Pharmaceutical company Merck, another DJIA component, has a 5% dividend yield.

Some critics argue that investing in dividend-paying stocks comes at the cost of growth. That, however, is not always the case. Since 1990, the top 20% of companies that have increased their dividends over time have had an annualized price return of 11.9%, compared with a 2.4% annualized price return for the bottom 20% of dividend growers, according to Oppenheimer research.

Mr. Belski recently screened dividend-paying stocks in search of strong dividend payers. Among the stocks that fit his screen: H&R Block, railway operator CSX, United Technologies and Johnson & Johnson.

Some investors might be better off investing in mutual funds that focus on dividend-paying stocks. Two such funds are the BlackRock Equity Dividend fund and the Columbia Dividend Income fund. It's important to read an "income" mutual fund's prospectus and look at its track record. A lot of income funds aren't terribly focused on dividend-paying stocks, despite their name.

While dividend-paying stocks are usually sturdy and stable, that isn't always the case. For instance, during the recent financial crisis many companies, such as General Electric, slashed their dividends to preserve cash. Often, just ahead of a dividend cut, a company's dividend yield will balloon to huge, usually unsustainable levels.

No Guarantees

Also, paying a good dividend doesn't guarantee safety. Financial companies have historically been healthy dividend payers. But the fact that Lehman Brothers, Bear Stearns and Merrill Lynch all paid decent dividends ultimately had little bearing on the safety of those stocks.

Indeed, some money managers think dividends are an overrated and inefficient way to invest. "Dividends are fine, but they can go down or even go away," says Ethan Anderson of Rehmann Financial in Grand Rapids, Mich. "I'm not saying great stocks don't pay dividends. I'm saying a great dividend does not mean a stock is great. In my opinion, dividends are like stock splits -- good for marketing."

Mr. Anderson says dividend-paying stocks, such as utilities, are generally more stable stocks, but he prefers to focus on earnings and growth. Rather than counting on dividends for income, he says, investors can simply sell stocks if they need the cash.

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