Dividend investors at a crossroads

When red ink splashes across your stock portfolio's statements, as it might be doing now, you could consider fleeing to stocks of companies that pay dividends. At least this way, you'd pocket some reward as stock prices swoon.

Or, maybe you shouldn't act too fast: Amid a changing market cycle and with possibly higher tax rates ahead, questions are arising about the allure of dividends.

Certainly, the long-term performance of dividend-paying stocks have been eye-catching: Over the 36 years ended Jan. 31, 2008, firms in the S&P 500 stock index that initiated or raised their dividend posted a 10.5 percent compound annual return. Over that same period, companies in an equal-weighted S&P 500 index had an 8.1 percent return and nondividend payers in this index produced a paltry 2 percent showing, according to Ned Davis Research.

"Stocks of dividend-paying companies … tend to be a port in the storm," says Ed Clissold, senior global analyst at Ned Davis Research in Venice, Fla. "When capital appreciation is weak or negative, investors still get the advantage of total return boosted by dividends."

And when investors take dividend payouts, they can get a useful income stream – money to pay bills or even to buy stock in another company.

As baby boomers age, many experts see more of them gravitating to dividend payers for retirement income. In order for retirees to make their assets last through their lifetimes, they "should only tap 4 to 5 percent of their investable assets per year" for living expenses, notes Greg Donaldson, whose firm, Donaldson Capital Management in Evansville, Ind., specializes in managing portfolios of stocks of dividend-paying firms. "If people invest in common stocks that yield 4 percent to 5 percent, they may never have to dig into their principal."

In this decade, investors found added reasons to embrace dividend-paying stocks. On the market front, the tech-stock meltdown early in the decade helped trigger a swing away from growth stocks to value issues – the category many dividend payers fall into.

Added to that trend was the favorable change in tax rates on stock dividends. In 2003, the federal individual income-tax rate on qualified dividends dropped to a maximum 15 percent. Experts say that change spurred more companies to raise or initiate dividend payments and heightened the appeal of dividend-paying shares.

Indeed, after that tax-rate cut, "the amount of income distribution passed on to investors increased significantly," reports Tom Roseen, senior research analyst at Lipper, a mutual fund tracking company.

But looking ahead, trends seem less promising for dividends and their payers. Financial planner Steven Kaye, president of the American Economic Planning Group in Watchung, N.J., points out that the market cycle has tilted in favor of growth stocks since last year. In his view, the current pro-growth trend could last "at least a couple of years."

Meanwhile, some large companies recently have made dividend cuts. One oft-cited example: Citigroup's January announcement of a 41 percent shearing of its quarterly common stock dividend to 32 cents per share. In all, this year through Feb. 19, seven S&P 500 companies – all in the financial sector – have announced a dividend cut or suspension, compared with 13 such moves by companies in the S&P 500 in all of 2007, according to data from Standard & Poor's.

Although cash dividends are growing – by an expected average 9.3 percent among S&P companies this year – these percentage increases have been slowing, evidently as companies opt to pour money into stock buybacks.

Beyond market factors, experts cite rising concern about the prospect of higher taxes on dividends. Unless Congress intervenes, the current dividend tax rate is set to expire at the end of 2010 – an issue that's already being discussed in the current presidential campaign.

Without the favored tax rate, at least some observers believe that dividend-paying companies could lose part of their draw. Indeed, a 2007 survey by Eaton Vance of 375 financial advisers and 402 investors age 61 and older, showed somewhat differing outlooks from the two groups on the effects of a possible higher dividend tax rate. Among other findings, the survey found that "many" advisers believe that if the 15 percent maximum rate is repealed or expires "investors will increasingly favor other income-oriented vehicles over stocks. And 58 percent [of respondents] predict companies will deemphasize dividend payments in favor of capital expenditures and stock buybacks."

But data show seniors responding to the same survey were more sanguine: If the dividend tax cut is repealed, "more than half [of senior investors] say they will not adjust their portfolios, and only 18 percent say they will invest less in dividend-payers," says the survey report.

Moreover, this year's performances of the dividend-paying group have been encouraging. For instance, in January, the 387 dividend payers in the S&P 500 stock index posted an average 4.1 percent drop in total return – beating the 113 nondividend payers in the index by almost two percentage points.

For those shopping for such stocks, there's no shortage of companies to choose from. To help find and research them, Mr. Donaldson cites such websites as www.dividendachievers.com and www.dividendinvestor.com. In addition, Standard & Poor's provides information on S&P 500 dividends at www.marketattributes.standardandpoors.com.

Indeed, as one source of individual shares, the S&P 500 index "is loaded with dividend payers," says Howard Silverblatt, S&P's senior index analyst. Fully 77.6 percent of companies in the S&P 500 index pay cash dividends – versus 38.8 percent of non-S&P 500 companies, he reports.

In addition, Morningstar counts 23 exchange-traded funds and 54 mutual funds in its universe that have the word "dividend" spelled out in their name.

For his part, Donaldson likes companies "with a long history of raising their dividend every year." He cites five stellar examples: Colgate-Palmolive, Procter & Gamble, Coca-Cola, Vectren, and Progress Energy. These companies, Donaldson says, not only have raised their dividend annually for at least the past 20 years, but also have a stock whose price has bested the market over the past turbulent six months.

But for those investors seeking dividend-paying companies, there's also a widely agreed-upon cautionary rule of thumb: Don't pick companies with sky-high dividend yields, say in the 14 to 15 percent range. In that case, such yields can signal that a company is in financial trouble – and that its dividend-payout level may not be sustainable.