Dividends: Cash in Your Pocket

Dividends: Cash in Your Pocket

After a recent ill-fated spin in the fast lane, many investors are rediscovering the value of a more conservative approach toward increasing wealth: the cash dividend.

For most of the 20th century, dividends were an important component of the stock selection process, and with good reason. From 1926 through 2001, about 40% of the total return on an average large-cap U.S. stock was generated by its dividend (Fortune, July 2004). Remember, past performance is not a guarantee of future results. Yet as the high-tech mania gathered steam in the late 1990s, stocks that paid healthy cash dividends frequently were overlooked in favor of those that promised the opportunity to grow earnings at a rapid pace well into the future.

Many of those promises turned out to be empty, sending many expensive growth stocks plunging. Yet amid the ruins of the 2000-2002 bear market, investors learned that even though the economy may destabilize, some investment rules never change.

?A dividend is cash in your pocket,? says Tim Johnson, a Nashville, Tenn.-based National Resource for Investment Planning at Lincoln Financial Advisors. ?A company's stock may bounce around, but dividends once paid cannot be taken away. It's yours to do with as you please.?

Financial Barometer
Even Uncle Sam has come to recognize the importance of those quarterly cash payments. The Jobs and Growth Tax Relief Reconciliation Act of 2003 slashed the tax rate on dividends to 15%, putting it on roughly equal footing with capital gains. In addition, recent legislation extended the lower rate on dividends through at least 2010.

Besides being cash in your pocket, dividends can serve as the proverbial canary in the mine shaft for investors concerned about accounting irregularities like those that burned shareholders of Enron and WorldCom.

?The ability to pay a cash dividend can be an indication of sound corporate financial health,? says Johnson. ?That cash dividend tells you that the earnings are real. Companies can't distribute money that they don't have for very long.?

In addition, the earnings and stock prices from dividend-paying companies tend to be less volatile than their non-paying counterparts, says Johnson.

?When you remove emotion from the selection process, determining what a stock is worth is really a mathematical exercise, albeit a complicated one,? he says. ?It's a matter of determining what the current value is of all future income streams, and dividends are a major part of those income streams. That's why stocks that pay steady and rising dividends typically suffer less downside volatility.?

Focus on Long-Term Prospects
Though a high-dividend yield can be alluring, Johnson cautions that it might represent a trap in some circumstances. ?People think that if something is good, then more is better,? says Johnson. ?And if more is better, then a tremendous amount of it is tremendously better. But that's not always the case.?

In general, professional money managers are in the best position to determine why a company is paying out an above-average amount of cash. It could be that the business has virtually no growth prospects or that the dividend will be cut in future years. The higher the current yield, the higher the current risk.

A company's record of increasing dividend payments is often a much better barometer of investment value than simply a high current yield. Based on an investor's original cost basis, for instance, a 2% dividend growing at 7.2% annually would reach 4% in 10 years and 8% in 20 years. Oftentimes, investors would be best served by taking a slightly lower current yield if the prospects for growing the dividend are good, says Johnson.

Keep a Diversified Portfolio
Buying stocks solely on the basis of above-average dividends may result in a lack of industry diversification. Since the highest payouts usually are found among companies in the financial and utility sectors, an investor focusing only on dividend yield could end up with a portfolio that's not adequately diversified, thus increasing the odds of experiencing severe downside volatility.

If handled skillfully, however, owning a broad basket of high-quality, dividend-paying stocks can be a valuable financial planning tool for long-term investors. Cash dividends can be used for real-life objectives like paying for a college education or funding retirement.

?Dividends make so much sense for so many people,? Johnson says. ?But as Shakespeare wrote, `There is many a slip 'twixt the cup and the lip.? In other words, choose carefully.?

To discuss how dividends can figure into your investment plans, please contact your financial planner. Together, you can focus on managing your assets and identifying strategies that can help you maximize your financial goals.

Talk to Your Financial Planner About:
  • Integrating dividends into your financial planning.
  • Which dividend-yielding stocks you may wish to invest in.
  • Strategies for maintaining a diversified portfolio.