With value shares outperforming growth stocks during the past two years, dividend-paying stocks have captured the attention of investors for the first time in more than a decade. Nevertheless, the impact of these income-producing stocks has dwindled. Only 70% of S&P 500 companies now pay dividends, compared with 87% a decade ago. As yields have dropped, dividend payouts are less than they once were. Today the dividend payout rate is just 30% compared with 50% a decade ago.
However, stocks that pay dividends tend to be less risky than those that don't. The dividends act as a cushion against stock market losses. No time has this been more evident than now. Through mid-August of this year, equity income funds-now classified by Morningstar Inc. of Chicago as "large-cap value funds"-have declined less than half as much as the average diversified non-dividend-paying stock fund.
For years, dividend-paying stocks had been synonymous with lower-risk solid returns. In fact, since 1926, dividends provided 4.7 percentage points of the S&P 500's average annual total return of 11%.
Mutual funds that invested in dividend-paying stocks did well with substantially lower volatility than the Standard & Poor's 500 index, the leading benchmark for large-cap growth stocks. The Franklin Rising Dividend Fund, which invested in companies that have a long history of increasing dividends, for example, sports a beta of just 0.44. But over the past 15 years, the fund has performed as well or better than the S&P 500. The T. Rowe Price Dividend Growth Fund has a beta of just 0.57, but has outperformed the S&P 500 by 4 percentage points in annual return over the past three years, Morningstar reports.
During the 1990s, dividends fell out of favor due to changes in the tax laws. Since 1993, dividends have been taxed at a higher rate than capital gains. They also are subject to double taxation at both the corporate and investor level. The reduction of the capital-gains tax rate made growth stocks more attractive and increased the incentive for companies not to pay dividends. In the 1990s, dividends provided just 2.9 percentage points of the S&P 500's 18.2% average yearly return. The S&P 500 index posted 18.2% average yearly returns between 1990 and 1999. Profitable companies shunned dividends, preferring instead to reinvest cash in their businesses or buy back their own shares.
In the wake of all the corporate accounting scandals, dividend-paying stocks may once again have their day in the sun. "Investors are placing a premium on financially sound companies," says Morningstar analyst Scott Cooley. "Companies that increase their dividends are signaling their earnings are growing."
Despite the decline in the number of dividend-paying companies and lower dividend-payout rates, financially strong companies producing solid earnings are looking for ways to pass them on to shareholders. "Dividends are normally a more stable and predictable component of total return than capital appreciation," says Thomas Huber, manager of the T. Rowe Price Dividend Growth Fund. "Companies that pay consistent dividends tend to be pretty durable businesses, which can lead to less volatility."
Huber believes that if stock market performance returns to its historical average of around 11% per year, dividends will feature more prominently as a percentage of total return. Meanwhile, Edward Bousa, manager of The Hartford Dividend and Growth Fund, says more companies are likely to opt for paying dividends than buying back shares.
"Companies have learned that having a strong balance sheet is important," Bousa says. "Companies that embarked on huge share buy-back programs and levered up the balance sheet have paid the price for it. I would expect more companies to have a dividend as opposed to a share buy-back policy. Investors will know their earning power is here to stay."
Recent financial research shows that investors should take dividends more seriously. A study by Roni Michaely, Ph.D., finance professor at Cornell University in Ithaca, N.Y., found that firms had statistically significant increases in earnings the year before they increased their dividends. Companies that initiated or raised dividends outperformed companies that didn't by a total of 8% over the next three years. Michaely also found evidence that companies raising dividends are "less likely to have subsequent earnings decreases than firms that do not change their dividends despite similar earnings."
Of course, the argument can be made that a company that retains earnings should show strong earnings growth. However, that depends on how efficiently management allocates capital.
A study published by Cambridge, Mass.-based David L. Babson & Co. Inc. in The Babson Staff Letter argued companies that had high dividend-payout rates had better inflation-adjusted profits compared with firms that retained earnings. The researchers compared rolling 10-year periods of real earnings growth based on payout rates from 1950 through 2001. The results show that the top 25% of companies with the highest payout ratios and the least amount of retained earnings generated an average inflation-adjusted profit growth of 3.2% annually. By contrast, the 25% of companies with lowest payout ratios averaged just under 1% annual inflation-adjusted profit growth.
"Dividend policy comes down to management's ability and preferences in allocation of capital," says Edwin Everett, an analyst with David L. Babson & Co. "Cash dividends force discipline on companies, especially in allocating resources."
Fund managers that specialize in investing in companies with a history of increasing their dividends say that their funds have performed as well or better than the S&P 500 with less risk. Franklin Rising Dividend Fund only owns companies that have a history of paying dividends and are trading in the lower half of their 10-year P/E range. A company's long-term debt cannot be more than 50% of its total capital. They must double their dividends over 10 years. And the percentage of earnings paid out in cash to shareholders must be less than 65% of total earnings.
The fund owns stocks, like Family Dollar Stores and Alberto-Culver, which each have increased their dividends over 25 and 17 years, respectively. "Our investment strategy is based on the belief that companies with consistently rising dividends should realize appreciation in stock prices," says the fund's manager, Don Taylor.
Taylor, whose fund is up 4% annually over the past three years, says he is seeing a stronger demand for dividend-paying stocks. Meanwhile, the supply of companies that have a history of increasing dividends is limited.
"In the past, institutional investors were investing in companies that bought back their own stocks," he says. "Now we are in the early stages where they are starting to change and buy dividend-paying stocks." He expects the increased demand to influence more companies to pay dividends.
In April, Taylor bought General Electric. The stock fell substantially since the bear market began. GE yields 2.5% and has grown its dividend 14% annually over the past 10 years. A month earlier, he bought Old Republic International and Hillenbrand Industries. He believes Hillenbrand Industries, a leading provider of funeral and health-care products, should benefit from the aging population. It has 31 years of dividend increases. Meanwhile Old Republic, an insurer of specialty property, mortgages and titles, has raised its dividends for 21 consecutive years.
Taylor says the fund's 10 largest holdings-about one-third of the portfolio-have raised their dividends for 20 consecutive years. "I look at the dividend as part of the capital allocation process," Taylor stresses. "I want to own good-quality companies that generate high returns on capital."
T. Rowe Price Dividend Growth Fund, which yields 2.5%, also invests in companies with long-term track records of increasing dividends. Fund manager Huber sticks with financially strong companies that have typically raised dividends in five of the last 10 years. The companies have high profit margins and a lot of free cash flow to pay dividends, buy back stock and make acquisitions. The fund's average holding grows revenue at 11% annually and earnings at 13% annually. "If you believe normalized returns on stocks will be 6% to 9%, picking up dividends of 2% to 3% makes a difference in total returns."
Huber used the market meltdown in July 2002 to buy some attractive dividend-paying stocks such as Home Depot. The stock is down 50%, but the company has a solid balance sheet and $5 billion in cash earnings. It has a history of increasing its dividend, and it sells at just 15 times 2003 earnings, while earnings are growing at 20% annually.
Huber also snapped up Verizon. The stock was hit hard due to the company's debt. But Verizon is paying down its debt and is selling at just nine times next year's earnings. The stock yields 5% and earnings are growing at 7% annually.
Eli Lilly, as well as other drug stocks, has been a poor performer. However, the company has the strongest pipeline of new drugs that may come to market. The stock yields 2% and earnings are growing at 15% annually.
Bousa of the Hartford Dividend Growth Fund wants to own financially strong companies when they are out of favor. But the companies must show the ability to grow market share and sustain dividends. The fund has outperformed the majority of its peers this year. The fund yields more than 2% and owns companies growing earnings at a steady 12% clip.
For example, Procter & Gamble is one of the fund's largest holdings. The company has been paying dividends each year since 1890. It has raised its dividend each year over the past 47 consecutive years. In June, the company increased its dividend by almost 8%. And the company's earnings are growing at a solid rate of 10% annually. "Dividend-paying companies are focused on returning cash to shareholders and meeting return on capital targets," Bousa says. "They are less likely to make poor business decisions."
In recent months, Bousa says he took profits in cyclical stocks. He put money to work in large telephone, telecommunications and health-care companies. He increased his holdings in Verizon Communications, IBM and Pharmacia.
The fund is overweighted in material, industrial and utility stocks. High-yielding stocks, such as Avery Dennison, Procter & Gamble, Exelon and Wachovia, have contributed to the fund's relatively strong performance.