Dividends Rule! For two generations growth stocks have dazzled investors, but the new tax laws should change the way you think about your portfolio
(MONEY Magazine) – The gospel of investing doesn't always prove true, as the preceding story shows. But since the 1960s, one tenet of faith has remained firm: The best way to build wealth is to buy and hold growth stocks--staking your financial future on the shares of companies that increase their earnings by more than 12% year after year.
These glamour stocks rarely pay much in the way of dividends, on the theory that investors do better when profits are reinvested to fuel earnings growth. Retirees who need cash to live on should own old-line blue chips that pay shareholders every three months, the gospel says. But to build wealth, you want growth.
Right now I believe the market is at the beginning of a fundamental shift that will increase the value of dividend-paying stocks and make them the preferred vehicle for most investors--much as they were for decades before growth investing became dominant in the 1960s.
The reason is simple: The decline over the past 20 years in marginal tax rates, and especially last year's slashing of the dividend tax rate to 15%, magnifies the appeal of dividend-paying issues. Instead of keeping just 51¢ of each dollar of additional dividends, as affluent investors did in 1980, today you get to keep 85¢ (see the chart on the next page).
Lower tax rates eliminate most of the advantage that growth stocks have long enjoyed over dividend stocks. And on a level playing field, stocks that yield 2% to 4% a year in dividends should outperform the glamour crowd by delivering equal or better returns with greater predictability and lower risk.
GROWTH WASN'T ALWAYS TOPS
There's historical precedent for favoring stocks with ample dividends. Following the Great Depression, investors focused on conservative stocks that paid investors 4% to 6% of the share price every year. The big shift to growth came as the postwar economy boomed. Equally important, inflation began to spiral upward, leading investors to favor shares with earnings growth that could stay ahead of consumer price increases.
Since then, growth stocks have endured several booms and busts, but they've never ceased to entice investors. One big reason: the tax benefits accorded to capital gains.
Basically, companies have two choices for what they can do with money beyond what they need to maintain their existing businesses. They can reinvest it, or they can distribute it as dividends to shareholders. As long as a company can find profitable enough places to reinvest, its earnings should rise consistently and the share price should follow. Shareholders, meanwhile, don't have to pay taxes on the earnings that companies reinvest, and they avoid capital-gains tax until they sell their shares.
By contrast, dividends are taxable each year. And until last year, they generally were taxed at ordinary income rates. Long-term capital gains, by contrast, usually were taxed at lower rates, sometimes only half that for dividends.
THE CASE FOR DIVIDENDS
But now tax rates on capital gains and dividends are 15%, and that means the pluses of dividend-paying stocks and the problem at the heart of growth investing come to the fore.
Here's the Achilles' heel of growth stocks: There simply aren't enough great opportunities for reinvesting earnings. So what happens is that companies build up cash hoards. Since 1999, in fact, the cash held by nonfinancial companies in the S&P 500 has more than doubled, to $555 billion.
That much cash can be a burden. The company may end up investing in less profitable businesses, making acquisitions that don't work out, or simply letting the money sit earning low rates of interest. The solution is to distribute it to shareholders. Microsoft's announcement in July that it would pay a $32 billion special dividend and double its regular dividend is only the most spectacular example of a practice that is likely to become increasingly common.
Returning money in the form of dividends has several benefits. Shareholders get a predictable return. They also get to choose where to reinvest; they can use the dividends to buy more shares, or they can find a better investment. Meanwhile, the company's resources remain focused on its most profitable operations.
The advantages dividend-paying stocks offer become obvious if you compare them with other categories of stocks. Dirt-cheap companies that have little earnings growth can rebound for a year or two but can't outpace the market over the long term. At the opposite extreme, companies with exceptionally high earnings growth rates--say 25% or more--typically have trouble sustaining their performance and can drop like a rock on the slightest bad news.
The choice for conservative, long-term investors is between two types of stocks that can provide potential total returns of 12% to 16% a year--those that pay little or nothing in the way of dividends and those that offer meaningful yields.
Over the long term, stock prices rise in line with earnings per share. So if there are no tax advantages, a stock with 12% compound annual growth doesn't deliver any more return than one with 9% growth and a 3% yield. The only difference is that the first pays off entirely through a rising stock price (theoretically averaging around 12% a year), while the second offers 9% average gains and a predictable 3% in cash distributions each year. Moreover, the dividend-paying stock has to meet less demanding quarterly earnings targets--and its share price gets support from the yield in the event of a general market decline.
These advantages are always true, of course. What makes dividend stocks especially attractive right now is the tax cut. Indeed, the impact started showing up almost immediately after it was signed into law in May 2003.
THE SHIFT HAS BEGUN
The percentage of companies paying dividends, which had been declining for 20 years, began to rise. So for this year, 170 firms have declared dividends for the first time. And dividends paid by the S&P 500 are projected to jump nearly 14% for the year. That would boost the yield of the stocks in the index to 1.8%.
The reason companies are hiking their payouts, of course, is to attract potential shareholders now that dividends are worth more. But there's a bigger question: Will dividend stocks rise in price to reflect their improved competitive position?
WILL SHARE PRICES RISE?
Some revaluation has already occurred. Stocks in the S&P 500 that pay dividends have outperformed nonpayers by 11.4 percentage points this year, and the difference in price/earnings ratios between growth stocks and blue chips is about half what it was in 2000. But that's mostly due to the sharp drop in the prices of growth stocks during the bear market. The gap could narrow further as investors embrace dividend stocks.
Why that hasn't happened is a fair question. An old joke provides a partial answer: Two economists are out for a walk, and one sees a twenty-dollar bill on the ground. "That can't be a twenty," his companion says. "Someone would have picked it up."
The stock market doesn't adjust instantaneously; an opportunity can be obvious and yet still exist.
In addition, the law cutting taxes on dividends comes up for renewal in 2008, and John Kerry has said that if he's elected he'll push to roll it back for those with incomes over $200,000. But mainstream economic opinion today holds that eliminating high taxes on dividends is a net plus for the economy--and some form of dividend tax relief will likely prevail.
FIVE TOP PICKS
You might think that the smart strategy is simply to look for stocks with the highest payouts; find a company that pays 5% or more, and buy. But it turns out that dividend growth is even more important than current yield. Imagine you bought Bank of America 10 years ago, when it was yielding 3.8%. Since then the dividend has quadrupled, which means that the yield on your initial investment is now more than 12% a year after taxes.
The optimum strategy is to look for what are called growth and income investments. Seek out large companies that have strong balance sheets, yield between 2% and 4% and offer annual earnings growth of at least 9%. The best values will trade at P/Es of less than 20 times estimated 2005 results. Subscribers to MONEY can get regular coverage of such stocks by signing up for my online column at money.com/sivy. Here's a look at five stocks that meet the criteria.
-- ABBOTT LABORATORIES For the second quarter, this leading pharmaceutical company reported a 14% earnings gain. Eight of its major drugs are growing at double-digit rates. The star has been Humira, a treatment for rheumatoid arthritis, which could reach $800 million this year. Current dividend yield: 2.7%.
-- CITIGROUP The financial services giant is still feeling the aftereffects of the bear market. Second-quarter results were overshadowed by a charge of nearly $5 billion for legal costs related principally to WorldCom and Enron. Apart from nonrecurring expenses, Citigroup's profits were up 24% for the quarter. Current dividend yield: 3.6%
-- DUPONT America's biggest chemical company is in the midst of cost cutting. The goal is a $900 million reduction in expenses by 2005, largely by eliminating 6% of the work force. Because of the costs of the restructuring, the company has been cautious in its earnings guidance for 2004. But the core growth rate over the next five years should average nearly 10%. Current dividend yield: 3.3%.
-- GENERAL ELECTRIC Earnings were flat for the giant conglomerate in the most recent quarter. But most of the trends were quite positive. Nine of the company's divisions showed double-digit revenue increases. Overall, revenue was up 11% and orders rose 13%. Current dividend yield: 2.5%
-- LIMITED BRANDS This retailer's chains include Express, The Limited and Victoria's Secret. In June the company posted strong 19% gains for stores that were open a year earlier. The Limited chain appears well positioned for the fall, with fashion trends expected to favor preppy styles, muted colors and a more tailored look. Current dividend yield: 2.4%.