This article appeared in the November issue of MONEY Magazine; prices and yield data have been updated as of November 5.
NEW YORK (MONEY Magazine) -- Good old dividends.
In the giddiness of the market bubble of the late 1990s, it was easy to forget that the lowly dividend accounted for half of stocks' investment return over the past 100 years. As the century rammed to a close, the number of companies paying dividends fell by two-thirds to 21 percent, down from 66 percent in 1978.
Now that accounting scandals and executive shenanigans have made investors distrust financial statements and promises of unfettered earnings growth, dividends have regained their appeal. For one thing, they serve as direct evidence of a company's financial strength. And for another, the prospect of ready cash can help support stock prices in tough markets.
Morgan Stanley market strategist Steve Galbraith believes that the appeal of cold, hard cash "will continue to drive stock performance for some time."
Back in style
Now many believe that we're in the early stages of a dividend renaissance. The number of companies that have boosted their dividend since July is up more than 30 percent year-over-year, and some companies are instituting dividends for the first time. In May, for example, FedEx announced that it would start paying dividends; FedEx CEO Fred Smith called the new policy a sign of "the board's confidence in the company's future growth and financial prospects."
| * As of 11/5 |
| Source: Baseline|
So how should investors incorporate dividends into a portfolio? Traditionally, yield-hungry investors turned to utilities, many of which no longer offer the sizable, secure dividends they once did, and to real estate investment trusts (REITs). We think that investors need to take a broader approach, looking for stocks that combine a safe dividend with the potential for growth.
With that in mind, here's what you need to know about choosing exceptional dividend-paying stocks.
Higher is not always better. Falling share prices have pushed yields to new highs (since yield is the dividend per share divided by share price). Of the companies in the S&P 500 that pay a dividend, 71 percent have yields above their five-year average. But a double-digit yield like the 14 percent that WorldCom tracking stock MCI Group sported in 2001 can point to serious business problems on the horizon. Eventually, WorldCom eliminated the tracking stock, a move that allowed it to avoid paying $284 million in dividends.
Look beyond a stock's yield to the payout ratio. The payout ratio (dividend per share divided by earnings per share) tells you how much of a company's profits go to pay the dividend. Money managers prefer to see the ratio stay under 50 percent for two reasons. First, even dividend payers need to be able to reinvest in their businesses; a high payout ratio could indicate that the company is starving its operations to maintain the dividend.
And second, those companies may eventually have to cut, or at least stop increasing, their dividends. John Snyder, manager of John Hancock Sovereign fund, believes that J.P. Morgan Chase and Bristol-Myers Squibb, where earnings troubles have pushed dividend payout ratios above 65 percent, may fall into that category.
A recent study of dividend-paying stocks in the S&P 500 by Credit Suisse First Boston analysts bears out the benefits of the low payout ratio. For the 12-year period that ended in June of this year, the study found that stocks that combined high yields with low payout ratios performed better than those with high yields and high payout ratios.
Seek steady dividend growth. To boost the dividend, the company must first increase earnings. "Companies with rising dividends tend to have more consistent earnings and also very good balance sheets and cash flow," says John Hancock's Snyder, whose fund has 80 percent of its assets in steady dividend-boosters.
Taylor's Franklin Rising Dividends looks for companies that will double the dividend every 10 years, which translates to an annual increase of roughly 8 percent compounded.
Solid dividend plays
Arthur J. Gallagher Taking these tips to heart, we searched the market's dividend-paying stocks, looking for a long record of dividend increases, low payout ratios and healthy cash-flow growth. One of the names that showed up is commercial insurance broker Arthur J. Gallagher. The stock plummeted in July after its second-quarter earnings disappointed investors.
But Don Taylor, manager of the Franklin Rising Dividends fund, says the shortfall resulted largely from higher expenses as a result of the hiring of a lot of new agents, which should lead to stronger growth in the coming quarters. Sales at the $2 billion (market capitalization) company still grew 22 percent for the first six months of the year, while earnings rose 36 percent.
At around $27, shares trade at 14.2 times next year's estimated earnings, and the stock yields 2.2 percent. The company, which has a payout ratio of 38 percent, has raised its dividend by 68 percent over the past five years.
Washington Mutual Another fallen stock that looks like a solid bet is Washington Mutual. When MONEY last recommended this bank stock back in September, it had sunk to new lows, in part because of fears that a rash of mortgage refinancings would cut into Washington Mutual's earnings. It now trades for about $36, with a 3.1 percent yield.
Taylor thinks that the fears about the impact this latest round of mortgage refinancings will have on WaMu are overblown. "People should be thinking how good the loan servicing business will look after this cycle is over," he says. "If interest rates move back to where they were as recently as March, it may be a long, long time before the bank has to deal with a huge surge of refinancings again."
Bank of New York is another blue-chip bank that offers a better-than-average yield. Its stock tumbled after the company warned recently that bad loans would eat into third-quarter earnings, pushing its yield up to 2.8 percent. But the company's management is well known for its tight control over its loan portfolio, and John Hancock's Snyder thinks that the current problems are short-term.
Abbott Laboratories A dividend payer that Snyder favors is drugmaker Abbott Laboratories, whose stock has been hurt by a federal inquiry into one of its manufacturing plants. Snyder believes that the company is sound; its sales and cash-flow growth have remained healthy, and it has a promising new rheumatoid arthritis drug in the pipeline. Best part: its 2.2 percent yield is well above its five-year average, and it has hiked its dividend 56 percent in the past five years.
Citigroup Geraldine Weiss, who runs Investment Quality Trends, a newsletter devoted to dividend-paying stocks, points to Citigroup as a good dividend play today. Weiss starts her research by screening a database of the historic yields of some 400 stocks to determine whether they are overvalued or undervalued. As long as other fundamental research on a company checks out, says Weiss, "if you buy stocks at the high end of their yield profile and have the patience to wait, you'll have a very successful investment."
If you prefer to invest using mutual funds, several strong choices make dividend investing part of their strategy. No-load MFS Value holds at least 65 percent of assets in dividend payers. This eye for income led managers Lisa Nurme and Steven Gorham to load up on stocks like Bank of America (yield: 3.7 percent) and Citigroup. Over the past three years, the fund has broken even, ranking it second among all large-cap value funds, according to Morningstar.
Another good choice: Taylor's Franklin Rising Dividends, whose three-year annualized return of 5.4 percent ranks it 14th among its peers. Along with Arthur J. Gallagher, the fund owns Alberto Culver and Family Dollar Stores. Since spring, Taylor's been adding to his GE stake; its 35 percent dive this year has sent its yield to 2.7 percent.