Sivy on Stocks

Selecting stocks for income
There's something to be said for steadily rising dividends.
August 18, 2004: 10:06 AM EDT

NEW YORK (CNN/Money) - "Show me the money" is the cry of income investors. They don't want to gamble on explosive earnings growth or higher valuations. They want safe, reliable cash payouts that rise faster than inflation.

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Actually, there's a good case for including income investments in any portfolio, because they add ballast when the market gets choppy.

There are plenty of income vehicles, but shares of companies that pay dividends have an important advantage over many of the alternatives. Bond payouts don't increase over time, for example, but dividends do rise for most income stocks.

Historically, blue-chip stock yields have averaged almost 4 percent, accounting for nearly one-third of the S&P 500's total return. And most of the time, yields have ranged between 3 percent and 5 percent.

We're in an exceptional period now, however, with the yield on the S&P 500 under 2 percent. Nonetheless, finding stocks with yields of 3 percent or more isn't hard -- and it's a lot easier than it was five years ago.

You shouldn't focus entirely on current yield. Dividend growth is equally important. A stock that can raise its dividend 6 percent a year will double its payout over 12 years and quadruple over 24. If you hold long enough, even a stock with a modest initial yield could end up paying out far more than you could earn with a bond.

To evaluate an income stock, you should consider both the current yield and the likely dividend growth. Since dividends usually increase more or less in line with earnings, you can gauge a stock's long-term potential simply by adding the earnings growth rate to the current dividend yield. If a stock has 6 percent annual earnings growth and a 3.5 percent yield, for instance, its long-term return is likely to average about 9.5 percent.

You can compare that total return estimate to the yield available on bonds. If you figure that some investment-grade bonds pay 7 percent or 8 percent, income stocks will need potential total returns even higher to be top choices. Some utilities clear that hurdle.

The big risk to any income investment is an upsurge in inflation. You should therefore award extra points to any income investment that incorporates an inflation hedge. Oil stocks and mining shares, for example, would benefit from any increase in raw materials prices, and some of them pay fairly high yields.

One final note: Recent changes in tax law have sharply reduced the income tax on dividends paid by most U.S. corporations (some foreign stocks and other investments also qualify). This tax cut makes yield stocks more attractive relative to growth stocks than they've been in half a century.

Those tax benefits alone mean that income investing is more rewarding than it used to be. They could also encourage companies to raise their dividends and boost the share prices of stocks that already pay above-average yields. Whether you favor growth or income, that would be a win-win situation.  Top of page

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