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A tale of two yields
Is it better to get dividends from shiny condos or rusty industries? (Trick question.)
September 26, 2005: 4:05 PM EDT
By Stephen Gandel, MONEY Magazine

NEW YORK (MONEY Magazine) - If you want assets that pay generous dividends, you face a clear and simple choice today.

You can place your money in a sector that is one of the stock market's best performers over the past five years, a sector that still averages a dividend yield of 4.7 percent and that almost guarantees you'll draw an admiring crowd if you let slip at a cocktail party that, ahem, yes, you do happen to own a few thousand shares. That sector would be real estate investment trusts, or REITs, which invest in apartment towers, office parks, malls and other gleaming monuments to the real estate boom.

Or you can instead make your picks from among the lumbering giants of industry and finance in Standard & Poor's 500-stock index. These companies generally impress no one with their growth rates, and they traditionally pay dividends somewhere between modest and desperate. The average REIT is up 30 percent since the beginning of 2004, nearly triple the gain of the S&P 500.

So it's obvious which sector you should go with, isn't it? Why, the grimy old S&P, of course.

Okay, maybe it's not obvious. But investing smart is always a matter of looking ahead, not back, and when you do that today, you get a very different read on the two sectors.

After three years in the doghouse, the high-dividend stocks of the S&P 500 are trading below their historical averages. By contrast, a year and a half of thumping the market has left REITs at prices well above normal compared with the cash their properties throw off.

In fact, the REIT sector has gotten so far ahead of itself that at least one mutual fund is checking out. Westwood Management recently converted its strongly performing REIT fund -- up 27 percent in 2004 -- into the Westwood Dynamic Income Fund, pulling most of the portfolio's assets out of REITs and reinvesting into blue-chip stocks, among other things.

"We are concerned about the valuation of REITs," says Westwood's chief investment officer, David Spika.

As Spika knows, when you buy stocks for income, you need to be concerned about three things: the size of the dividend you get for your dollar (the yield); the odds that the dividend will increase; and whether the stock will rise or fall. On all counts, the outlook today favors high-dividend stocks over REITs.

Yields are almost the same

The most irresistible thing about REITs over the years has been their extraordinarily generous dividend yields. But those now stand at their lowest in more than 30 years, an average of 4.7 percent, down from 9 percent as recently as 1999.

That puts REITs in roughly the same ballpark as the highest-paying industrials and financials. The 50 highest yielders in the S&P 500 (excluding REITs) pay a dividend equal to 4.4 percent of their stock price.

That means REITs still have the edge -- until you consider taxes. Because the tax code treats REITs differently from other corporations, REIT dividends are taxed at regular income rates, which can run as high as 35 percent. Dividends from regular stocks get tapped for just 15 percent.

That can make S&P yields quite competitive. Of those 50 generous S&P stocks, 47 have better after-tax yields than the average REIT, according to Merrill Lynch analyst Steve Sakwa, another REIT specialist who is souring on the sector. (Among the most appealing of these S&P income stocks are Bristol-Myers Squibb (Research), Citigroup (Research) and Verizon (Research)) "REITs are not as attractive as they once were," says Sakwa.

S&P yields could rise

Stock yields, unlike those from REITs, have room to grow. The average S&P 500 company pays out 32 percent of its earnings to shareholders in the form of dividends. That's well below the historical average, 54 percent according to Standard & Poor's.

With more and more retiring baby boomers clamoring for income, Howard Silverblatt at S&P expects blue chips to continue to boost payout ratios. If that happens, their dividends could get a double boost -- from expanding payout ratios on top of growing earnings.

REITs, on the other hand, are required by law to pay 95 percent of their income to shareholders. So REIT dividends can't grow faster than earnings.

And because REIT earnings depend on the rental market, they're likely to grow slowly, if at all. The rush to own a home has held down apartment rents.

Corporations have been slow to increase the work force, reducing the need for office space and keeping rents cheap. And retail industry megamergers such as that between K Mart and Sears have reduced the number of stores available to fill malls, lowering rents there. As a result, Merrill's Sakwa expects REIT earnings growth to slow to 6 percent next year, from an estimated 6.4 percent this year.

"The growth rates implied by REIT prices are too high," says Sam Leiber, manager of the Alpine U.S. Realty fund. "I think REITs will disappoint."

REITs are riskier

The average REIT share trades at 15 times FFO (funds from operations, the preferred method for measuring REIT earnings) vs. a historical average of 12. Stocks in the S&P 500 trade at 19 times the past 12 months of earnings. But that's below the price-to-earnings ratio of 22 that stocks in the S&P 500 have averaged for the past 20 years. (Let alone the 27 they've averaged over the past ten.)

That means you take a much bigger chance if you pick REITs over blue chips. Suppose REIT earnings grow 5 percent a year over the next half a decade, as analysts are predicting, and by the end of that period they settle back to their historical average price in relation to FFO.

That would work out to a 5 percent loss in share price. Add in dividends, and an investment in REITs will be worth 22 percent more in 2010 than today.

Now take S&P 500 stocks, expected to grow 6 percent annually during the next five years. If by 2010 they trade at their historical P/E ratio of 22, price appreciation plus dividends will create a total return of 47 percent.

Mind you, this is not a prediction. No law says that stocks or REITs have to return to their average valuation in the near (or not so near) future. But it does strongly suggest which market sector is on the right side of the law of probabilities. And it's not REITs.


For more about investment strategies including REITs, click here.  Top of page

Blue chips for yield and value
All three sport higher after-tax yields than typical REITs. They're also undervalued compared with their five-year average P/Es.
Bristol-Myers Squibb (BMY)
Price: $24
Undervalued by: 25%
Dividend yield: 4.7%
Expected five-year growth rate: 4%

• Bristol's pipeline is one of the industry's strongest.
• Abilify, a treatment for schizophrenia released in 2004, is nearing a billion in annual revenue. A medication for rheumatoid arthritis is set for next year. Cancer drug Erbitux is very promising.

The risk
• Even so, drugs that generate a third of Bristol's revenue will lose patent protection during the next three years.
• The company's shares carry a higher P/E than those of rival drugmakers Pfizer and Merck.
Citigroup (C)
Price: $44
Undervalued by: 27%
Dividend yield: 4%
Expected five-year growth rate: 11%

• The nation's largest bank has increased its dividend 35 percent since 2000.
• Its diverse mix of businesses -- Citi gets only half of its sales from lending -- means the company can continue to raise that dividend regardless of interest-rate hikes.

The risk
• Federal Reserve interest-rate increases are making lending less profitable for all banks.
• New chief Chuck Prince is restructuring, with the usual turmoil. Employees loyal to former CEO Sandy Weill have been leaving.
Verizon (VZ)
Price: $33
Undervalued by: 13%
Dividend yield: 4.9%
Expected five-year growth rate: 5%

• The nation's largest telco service provider generates $22 billion a year in cash.
• That cash flow should increase as Verizon expands into cable TV. Its wireless division, which added 2 million customers in the second quarter, continues to grow.

The risk
• Making its telephone network cable-ready will cost a lot -- $15 billion a year for the next few years.
• Meanwhile, many cable companies are nearly ready to start offering telephone service, increasing competition.
Note: Data as of Sept 1.
Source: Thomson/Baseline.
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