Back In Fashion: Dividends

By Daniel Kadlec

Here's a revealing tale that was on everyone's lips in the financial world last week. If you invested $1,000 in Nortel Networks a year ago, you would now have stock worth $82. If instead you spent $1,000 on Budweiser and drank it, you would have not just the obvious reason to smile but a subtle one too. On the basis of a nickel-per-can deposit, the empties would be worth $91. How's that for a New Economy slap in the face?

Nortel isn't alone. From Internet equipment to Internet retailing, the new new thing hasn't worked--not for investors anyway. So maybe it's time for an old, old strategy: investing for dividends.

During the '90s, investors didn't want dividends. They preferred that management drive up the stock price by reinvesting in the business or buying back shares. Those strategies worked in a fast-growing economy. And they worked for tax reasons because dividends are treated as ordinary income and thus typically taxed at a higher rate than capital gains.

No shock, then, that the share of earnings that S&P 500 companies pay as cash dividends has eroded steadily since the past recession, in 1991. Then companies paid out 75% of earnings as dividends. The ratio fell to an all-time low of 33% last year. Amid the current slump, some companies have cut their dividends--and others might join them as their profits get squeezed. Yet here's why dividend-paying stocks might come back:

BOOMERS RETIRING As the oldest members of the huge baby-boom generation approach retirement--and after the searing market drop this year and last--they will be looking for less risky investments. Dividend-paying stocks are just the thing. They tend to hold up better in weak markets because they guarantee income and yet preserve the likelihood of capital gains in a recovery. High yields may also signal value. The popular Dogs of the Dow strategy calls for buying the five highest yielding Dow stocks each year--usually the five whose prices have been beaten down the most. Results weren't great in the booming '90s but should improve in leaner times.

LOW INTEREST RATES Bonds, money-market funds and other interest-paying investments haven't carried yields this low since the 1960s. For income, it may make more sense to own a stock like Bandag, a profitable industrial-tire company with a dividend yield of 4.6%--about the same as on long-term Treasury bonds.

STRONG FUNDAMENTALS As investors look ahead to a recovery, they will favor stocks of familiar companies with solid balance sheets that do well on the rebound. Often such stocks also carry the highest dividend yields. Look at banks (AmSouth, U.S. Bancorp), basic materials (Dow Chemical, Lubrizol), energy (Consol Energy), manufacturers (Dana, Ford), real estate investment trusts (AMB Property, Federal REIT), utilities (Con Edison), and food and tobacco (UST, Philip Morris).

NEW MARKET REALITIES After years of soaring more than 20% annually, stocks are likely to rise much more slowly--something in line with, and maybe much lower than, the 10%-to-12% total return that blue chips have delivered over the past 75 years. As stocks' prices rise more slowly, their dividend income takes on greater significance.

FEWER GROWTH OPPORTUNITIES This global economic slowdown could be with us for years. That means firms have fewer chances for growth, no matter how much they reinvest. They can still use cash to buy back stock. But in a persistent bear market, a more certain way to reward shareholders is to raise the dividend.

TAX-DEFERRED ACCOUNTS The higher tax rate on dividend income is meaningless when a stock is owned in a tax-deferred account, like a rollover ira or a 401(k). Three of the best-managed equity- income stock mutual funds are Janus Aspen Equity income (with an annualized three-year return of 13%), American Century Equity Income (12.8%) and Van Kampen Equity Income (11.9%).

Remember that extreme dividend yields often signal a company in trouble. MCI Group yields an astounding 17.25%--and for good reason. So don't reach too high. But dividend stocks are a smart place to invest, whether the market keeps stumbling or turns up quickly.

For more news on stocks and the economy, see time.com/business