High-Flying Dividends

By Nellie Huang

For the past two years, the U.S. stock market has been at a virtual standstill as the Dow Jones industrial average has hovered at around 10,000. Investors are distrustful of corporate earnings reports and skeptical about Wall Street's projections.

So perhaps it's no surprise that stodgy dividend stocks--blue-chip companies with modest but consistent single-digit earnings growth--have returned as an investment of choice. As Frank M. Felicelli, portfolio manager of the Franklin Equity Income fund, puts it, "It's back-to-basics investing."

It's also smart. In a study done last year, fund firm T. Rowe Price compared the return of a $10,000 investment in the S&P 500 stock-index (with dividends reinvested) to a core fixed-income portfolio (Lehman Brothers U.S. Aggregate bond index). Over the 20-year period from 1983 to 2003, both portfolios generated roughly the same amount of income. However, in terms of overall value, the stock portfolio grew to $71,800, the bond portfolio to only $11,400.

The lesson for investors--even conservative income investors--is clear. By grounding your portfolio in dividend-paying stocks, over time you can enjoy the same regular payments that coupon-clipping bonds deliver with the dramatic upside of potential capital appreciation. The kicker: with most dividends now taxed at just 15%, many investors can get better after-tax returns from stocks than from bond yields, which continue to be taxed at personal-income rates as high as 35%. The number of firms paying dividends--376 of the S&P 500--has risen for the second year in a row after more than 20 years of declines. In the first 10 months of 2004, dividend payments were increased an average of 22% by 202 companies in the S&P 500.

Of course, investing in stocks rather than bonds does carry some greater risks. Your return of principal is not guaranteed, and a company can choose to cut its dividend. So how can you tell if a particular dividend payer is a wise investment? Start by looking at dividend yield--the annual payout divided by the stock price. Still, betting on a company solely because it carries a high yield is risky. In mid-October, for instance, department-store company Saks offered a dividend yield above 16%. But the stock had fallen 33% over the previous six months, and uneven sales trends have dogged the company for the past two years. This may turn out to be a spectacular opportunity for investors--but it carries significant uncertainties. Franklin's Felicelli suggests zeroing in on large blue-chip companies with a history of strong earnings growth and a management team that is dividend-centric. "You want a focus toward shareholders," he explains, "where companies have been growing cash flows and dividends over a period of time."

Here's a promising screen: we looked for dividend yields of between 2% and 4% (the S&P 500's yield is 1.68%), long-term earnings growth of better than 10% and a consistent hike in dividends. We looked too at the payout ratio--the percentage of earnings that is paid out in dividends. The lower the ratio, the easier it is for companies to meet their dividend obligations. Payout ratios vary by industry, but generally speaking, 50% or more is considered sizable; 75% or higher may be a red flag.

Three firms that passed our test: megabank Citigroup (share price as of Oct. 26: $43.34; 3.6% dividend yield; 49% payout ratio); Masco, one of the nation's largest makers of brand-name faucets, cabinets and plumbing supplies (share price: $34.41; 2.1% dividend yield; 30% payout ratio); and drugmaker Pfizer (share price: $28.33; 2.3% dividend yield; 50% payout ratio), whose latest dividend, in August, marked the 37th consecutive year of quarterly dividend increases.