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Alan Haft
 

Dividends: Man’s Best Friend?

Why your clients should be prepared for a dividend comeback.

December 20, 2010
by Alan Haft

Dividend investing was a popular strategy for obtaining income until the bull market of 1980s and 1990s made high-flying growth stocks all the rage — but that may be changing. In today’s market environment, which is dominated by improving corporate fundamentals and low fixed-income yields, dividend-paying stocks could re-emerge as an important component of investors’ portfolios.

Let’s examine why in more detail.

The Case for Dividend-Paying Stocks: Improving Corporate Fundamentals

Economic factors often affect a company’s decision to pay dividends. During economic slowdowns, many cyclical companies see their cash-flows decline, so they preserve capital in order to ensure their continued existence. That was particularly true during the most recent recession, when the availability of credit dried up to an unprecedented degree. In fact, 2009 was the worst year on record for dividends, according to the Standard & Poor index (S&P). The number of companies slashing dividends rose by 631 percent to 804 issues, while the number of dividend increases fell by 36 percent to 1191.

The result of the hoarding of cash during recessions, however, is often a release of cash in the form of dividends when the economy starts to stabilize and companies see improved earnings and renewed strength in their corporate balance sheets.

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This may be the case today. U.S. companies are currently sitting on more than $3 trillion of cash, which represents 14.9 percent of total assets on their balance sheets, according to FactSet as of September 30, 2010. Over the past year, says FactSet, a financial data and software company, companies within the S&P 500 index have increased their dividends per share by three percent.

Companies have two options for this cash: reinvestment or increased dividends. Many have recently chosen to increase dividends. One case-in-point is Microsoft, which in September 2010 announced that its board of directors had authorized a quarterly dividend of $0.16 per share, a move that reflected a $0.03 or 23-percent increase over the dividend issued the previous quarter. Another example: In November 2010, Equifax announced that it is increasing its quarterly dividend by 300 percent to $0.16 per share and placing a greater focus on dividends in the future by increasing its dividend payout ratio to 25 percent to 35 percent of adjusted net income.

But either option — reinvesting in the business or increasing dividends — could boost economic growth and lead to higher interest rates, in which case total returns of fixed-income securities would be negatively impacted, because bond prices move in the opposite direction of yields. And low prices of fixed-income make another compelling case for a comeback in dividend-paying stocks.

The Case for Dividend-Paying Stocks: Poor Performance From Fixed-Income Products

The past 10 years have seen two major bear markets in equities, both of which have led investors into the perceived safety of fixed-income products. For the past three years ending July 31, 2010, for example, bond funds have seen $644 billion in net flows, whereas equity funds have only $42 billion, according to Strategic Insight.

Yields on fixed-income products are almost unbelievably low. For example, we’ve recently seen a number of blue chip companies issue new intermediate-term bonds with coupons below three percent. In fact, 149 companies in the S&P 500 Index had dividend yields above their intermediate corporate bond yields as of September 30, 2010, according to FactSet.

This flight to safety, combined with expectations that the U.S. Federal Reserve Board could keep its benchmark federal funds rate low for some time to come, pushed the yield on the 10-Year U.S. Treasury below 2.5 percent in September 2010. That’s the first time since 1954 that has happened, according to the Fed.

As a result, dividend-paying stocks appear attractive relative to bonds right now. As of August 31, 2010, the spread between the 10-year U.S. Treasury yield and the S&P 500 Index dividend yield was only 50 basis points. That’s extremely narrow compared to the median spread of 328 basis points since April 1, 1953, which reflects the earliest records maintained by the Fed.

It’s certainly the case that interest rates could fall in the short term, leading prices of fixed-income securities to rise, but the writing is on the wall: at some point that Fed has to unwind the easing it’s put into place over the past several years and raise interest rates.

In preparation for this, many financial advisors are making the case that investors should prepare themselves for when interest rates eventually rise by stepping back into equities today.

In our opinion, it’s not a bad idea: Mutual fund net flows were this out of whack only one other time in the past 20 years, from the first quarter of 1991 to the third quarter of 1992 — and over the subsequent three years, from the fourth quarter of 1992 through the third quarter of 1995, the S&P 500 Index delivered cumulative returns of 51.89 percent, according to consulting firm Strategic Insight as of June 30, 2010.

Who Pays Dividends?

Dividends are typically paid by mature, stable companies that have achieved stable cash-flows and are confident that they will be able to support the dividend with future earnings.

But these companies aren’t necessarily slow-growth businesses. Certainly, traditional wisdom may suggest that companies with high-dividend payout ratios have lower earnings growth than companies with low dividend payout ratios. But take a look at the world and you’ll see that many companies with high-dividend payout ratios actually have higher earnings growth than companies with lower dividend payout ratios. A 2003 study published in the CFA Institute’s Financial Analyst Journal explained why: High-dividend payout ratios impose discipline on corporate management teams, forcing them to invest only in those projects with the best chance of adding value, which increases the company’s profitability.

Beyond mature, stable companies, dividends can typically be found in certain industries. For example, companies in industries with stable cash-flows, such as utilities, typically pay high dividends; companies in capital-intensive industries, such as aerospace, typically do not.

Many investors may also look abroad for dividend-paying stocks. To start, the international equity markets provide a broader universe of stock with high dividend yields. While there are 116 U.S. stocks with market capitalizations greater than $1 billion that have dividend yields greater than five percent, 530 international stocks meet those criteria, according to Morningstar as of August 31, 2010. Additionally, dividends may be higher abroad — developed Europe, emerging Europe, developed Asia, emerging Asia and emerging Latin America all offered higher dividend yields (1.92% to 3.07%) than North America (1.86%) as of August 31, 2010, according to FactSet.

Who Wants Dividends?

Your clients may want dividends especially those who are near retirement. There are currently more than 60 million baby boomers in the U.S. and most of them will retire over the next two decades. Most of these retirees will generate income in retirement through Social Security, but many will need to generate their income through their investment portfolios, in which case they may well be interested in investing in dividend-paying stocks. CPAs would be wise to be prepared to answer their questions with knowledge of dividend-investing strategies and tax implications.

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Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller,You Can Never Be Too Rich and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.

The AICPA’s Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. All members of the AICPA are eligible to join the PFP section. If you want an in-depth CPE course on investment planning, consider the new Investments course offered in partnership with The American College. The Personal Financial Specialist (PFS) credential is exclusively available to CPAs who want to demonstrate their expertise in this subject matter. If you are Series 7, 65 or 66 licensed, you have until 12/31/2010 to use that license as one of the qualifications to obtain the credential. Visit www.aicpa.org/PFP to learn more.

* For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.