Dividends and Total Return
Historically, dividends have provided a significant proportion of the stock market's total return. “From 1929 through 2004, dividends accounted for over one-third of the market’s total return” has been noted by some fund managers and investment officers.
During this time, there were extended periods when a greater percentage of stocks' total return came from dividends than from capital appreciation (using the S&P 500 Index as a proxy for the overall market). In the 1940s, for instance, 67% of the market’s 9.2% average annualized return was a result of dividends, while in the 1960s— when the market returned 7.8% annually — this number reached 73%.
Given today's expectations for limited capital appreciation, stocks that pay above-average dividends and mutual funds that invest in them are potentially attractive to a wider range of investors.
Why Have Dividends Come Back Into Favor?
Several factors provide an improved foundation for dividend-paying stocks:
Tax Advantage
The maximum federal tax rate on dividend payments is now just 15%, even for investors in higher tax brackets. A dividend payment now represents more cash in investors’ pockets than it did just two years ago. This has helped increase the demand for higher-yielding stocks.
Lower Interest Rates
Even after seven quarter-point increases by the Fed, money market yields remain in the neighborhood of 2.2%. Longer-term bonds are also offering relatively low yields: for most of 2004, the 10-year Treasury note paid between 4.0% and 4.8%. In this environment, the dividend yield on stocks has become more attractive. This is particularly true in light of stocks' greater potential for long-term capital appreciation.
Reliable Indicators
Dividends have also returned to their traditional role as a signal of a company’s current financial health and its prospects for the future. The ability to pay steady dividends and to increase the payout over time provides concrete evidence of a company's underlying financial condition. As a result, dividends — rather than financial reports or management statements — are now often viewed as a more reliable indicator of a company’s health.
Potential Outperformance
Higher-yielding stocks have the potential to outperform in down markets, since investors are attracted by the “cushion” dividends provide. Following the stock market downturn of 2000-2002, investors’ appetite for lower-volatility stocks has increased. It is important to keep in mind that a dividend, in itself, will not prevent capital erosion. However, on a historical basis dividend-paying stocks have generally outperformed during bear markets. Of course, past performance cannot guarantee future results.
Some Considerations
More Companies Have Increased or Begun Paying Dividends:
U.S. corporate behavior has responded to this increased demand for dividend-paying stocks. In 2004, the S&P 500 Index recorded 269 dividend increases, compared to 240 in 2003 — the largest increase in number since 1998. Perhaps the most notable sign of the times was the $33 billion special dividend payout by Microsoft, the technology giant that had hoarded cash throughout its 18-year history as a public company.
Given the record level of cash on corporate balance sheets, the trend of higher dividend payouts could continue. In addition, the yield on the S&P 500 Index is currently 1.8%, a half of what it was in 1991 and still well below its historical average of approximately 4.5% — another indicator that there could be substantial room for upside.
High Yields May Signal an Underlying Problem
Often, a high dividend yield can serve as a warning sign that a stock’s price might be depressed for a fundamental reason. Also look for companies with strong earnings growth, solid balance sheets, and attractive valuations. Yield alone is not a sufficient reason to purchase shares in a company.”
It isn’t necessary to give up growth to invest in dividend-paying stocks. Many companies with attractive yields are not slower-growth companies — they’re innovative world leaders. Investors don’t have to feel they are giving up growth potential by pursuing a dividend-focused strategy.
What Does This Mean For Investors?
Given the last two years' rapid increase in corporate earnings growth, many analysts expect a slower rate in the future. With the prospect for higher interest rates and the market's strong two-year gain, stock valuations are also unlikely to increase significantly. These factors may weigh on stock prices. Once you start thinking in terms of single digit returns the 2% to 2.5% yield you might get from dividends becomes a much more relevant part of total return.
Taken together, these factors may indicate that now could be a good time for investors to take a closer look at funds that invest a substantial portion of their assets in dividend-paying stocks. In a lower-return environment, even growth-oriented investors may benefit from the boost to returns that dividends can provide. In addition, investors who wish to maintain equity exposure but who are also concerned about short-term volatility should consider dividend-oriented funds as a lower-risk way to participate in the long-term growth of the stock market.
Mutual funds are subject to market risk, including loss of principal. The appreciation potential of a mutual fund with a dividend orientation may be somewhat less than a fund concentrating on rapidly growing smaller firms. Also, a company may reduce or eliminate its dividend.
During this time, there were extended periods when a greater percentage of stocks' total return came from dividends than from capital appreciation (using the S&P 500 Index as a proxy for the overall market). In the 1940s, for instance, 67% of the market’s 9.2% average annualized return was a result of dividends, while in the 1960s— when the market returned 7.8% annually — this number reached 73%.
Given today's expectations for limited capital appreciation, stocks that pay above-average dividends and mutual funds that invest in them are potentially attractive to a wider range of investors.
Why Have Dividends Come Back Into Favor?
Several factors provide an improved foundation for dividend-paying stocks:
Tax Advantage
The maximum federal tax rate on dividend payments is now just 15%, even for investors in higher tax brackets. A dividend payment now represents more cash in investors’ pockets than it did just two years ago. This has helped increase the demand for higher-yielding stocks.
Lower Interest Rates
Even after seven quarter-point increases by the Fed, money market yields remain in the neighborhood of 2.2%. Longer-term bonds are also offering relatively low yields: for most of 2004, the 10-year Treasury note paid between 4.0% and 4.8%. In this environment, the dividend yield on stocks has become more attractive. This is particularly true in light of stocks' greater potential for long-term capital appreciation.
Reliable Indicators
Dividends have also returned to their traditional role as a signal of a company’s current financial health and its prospects for the future. The ability to pay steady dividends and to increase the payout over time provides concrete evidence of a company's underlying financial condition. As a result, dividends — rather than financial reports or management statements — are now often viewed as a more reliable indicator of a company’s health.
Potential Outperformance
Higher-yielding stocks have the potential to outperform in down markets, since investors are attracted by the “cushion” dividends provide. Following the stock market downturn of 2000-2002, investors’ appetite for lower-volatility stocks has increased. It is important to keep in mind that a dividend, in itself, will not prevent capital erosion. However, on a historical basis dividend-paying stocks have generally outperformed during bear markets. Of course, past performance cannot guarantee future results.
Some Considerations
More Companies Have Increased or Begun Paying Dividends:
U.S. corporate behavior has responded to this increased demand for dividend-paying stocks. In 2004, the S&P 500 Index recorded 269 dividend increases, compared to 240 in 2003 — the largest increase in number since 1998. Perhaps the most notable sign of the times was the $33 billion special dividend payout by Microsoft, the technology giant that had hoarded cash throughout its 18-year history as a public company.
Given the record level of cash on corporate balance sheets, the trend of higher dividend payouts could continue. In addition, the yield on the S&P 500 Index is currently 1.8%, a half of what it was in 1991 and still well below its historical average of approximately 4.5% — another indicator that there could be substantial room for upside.
High Yields May Signal an Underlying Problem
Often, a high dividend yield can serve as a warning sign that a stock’s price might be depressed for a fundamental reason. Also look for companies with strong earnings growth, solid balance sheets, and attractive valuations. Yield alone is not a sufficient reason to purchase shares in a company.”
It isn’t necessary to give up growth to invest in dividend-paying stocks. Many companies with attractive yields are not slower-growth companies — they’re innovative world leaders. Investors don’t have to feel they are giving up growth potential by pursuing a dividend-focused strategy.
What Does This Mean For Investors?
Given the last two years' rapid increase in corporate earnings growth, many analysts expect a slower rate in the future. With the prospect for higher interest rates and the market's strong two-year gain, stock valuations are also unlikely to increase significantly. These factors may weigh on stock prices. Once you start thinking in terms of single digit returns the 2% to 2.5% yield you might get from dividends becomes a much more relevant part of total return.
Taken together, these factors may indicate that now could be a good time for investors to take a closer look at funds that invest a substantial portion of their assets in dividend-paying stocks. In a lower-return environment, even growth-oriented investors may benefit from the boost to returns that dividends can provide. In addition, investors who wish to maintain equity exposure but who are also concerned about short-term volatility should consider dividend-oriented funds as a lower-risk way to participate in the long-term growth of the stock market.
Mutual funds are subject to market risk, including loss of principal. The appreciation potential of a mutual fund with a dividend orientation may be somewhat less than a fund concentrating on rapidly growing smaller firms. Also, a company may reduce or eliminate its dividend.
posted by crg1 at 3:55 PM
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