TCS Daily


Show Me the Money

By James K. Glassman - February 13, 2002 12:00 AM

To many investors, the lesson of the Enron scandal is never to trust a company's earnings reports and balance sheets again. But that's nonsense. Yes, there are unscrupulous corporate managers and auditors out there, but the best way to protect yourself is not to dump stocks and buy Treasury bills but to diversify broadly and look carefully at the numbers. Next week I'll provide a primer on how some investors try to detect accounting shenanigans, but for now I have another suggestion: Look to dividends. In other words, show me the money.

Enron paid dividends all during the period when it now admits that it was overstating earnings, but those payouts were curiously flat at a time when the company's reported profits were soaring. For example, between 1997 and 2000, earnings rose 69 percent but dividends rose just 9 percent. That could have been a sign that something fishy was happening. A company might be able to fake out analysts by booking today paper profits that might possibly occur in the future. But dividends aren't entries on the ledger; they're real money. A company that consistently raises its dividend is almost always a well-managed company in a strong market niche.

Franklin Rising Dividends, a mutual fund that looks for firms with "consistent and substantial dividend increases," returned a spectacular 13 percent last year, beating the benchmark Standard & Poor's 500-stock index by 25 percentage points. Its top holdings include Family Dollar Stores Inc., the discount retailer; Washington Mutual Inc., the largest thrift in the United States; and Alberto-Culver Co., a toiletries company.

Just as impressive is Fidelity Dividend Growth. With a similar strategy, it has produced returns averaging 15 percent over the past five years, beating the S&P by 5 points -- and at considerably lower risk than the market as a whole. A third excellent fund in the same category, T. Rowe Price Dividend Growth, has soundly beaten the market over the past two years, again at relatively low risk. Large holdings include well-known large-capitalization stocks such as Pfizer Inc., Citigroup, General Electric Co. and Exxon Mobil Corp.

Unfortunately, dividends are getting more scarce. In 2000, a good year for profits, total dividends paid by the companies in the S&P 500 (roughly the 500 largest U.S. firms) fell 2.5 percent. In 2001, the decline was 3.1 percent -- the first time there's been a back-to-back drop in 30 years. And, for the first time ever, more than one-quarter of the S&P companies are paying no dividends at all. That's hardly surprising. Academic research shows that investors haven't been particularly enthusiastic about dividends -- mainly because of the way they're taxed. First the corporation has to pay taxes on its profits, then it pays dividends on what's left and investors pay taxes on the dividends. (The way around this double taxation is to own your dividend-paying stocks in tax-deferred accounts such as 401(k) plans and individual retirement accounts.)

Double taxation encourages companies to hold on to most of what they earn, whether the companies really need the money or not. While many firms use their profits wisely, investing in new plants and equipment from which more profits can be gleaned, others simply build up giant cash hoards or squander the funds on wasteful expansion. As Peter Lynch, the former manager of the Fidelity Magellan fund, once wrote, "Companies that don't pay dividends have a sorry history of blowing the money on stupid diversifications" -- like cash-rich Mobil's disastrous 1976 acquisition of Marcor, the holding company for Montgomery Ward, a retail chain that eventually went bankrupt.

Another popular way for corporations to dodge double taxation is to use their profits to buy their own stock. With fewer shares outstanding, each outstanding share is more valuable -- the equivalent of a tax-free stock dividend.

Still, taxes or not, I like dividends. They add ballast to a portfolio, holding down losses in tough times. Thomas Huber, who manages the T. Rowe Price fund, says: "Dividends are the only portion of stock return that is always positive. Earnings growth and share price appreciation certainly are not. This has been the painful lesson of the last year." With the combination of two years of declining stock prices plus the Enron scandal, the show-me-the-money approach should become more popular in the months and years ahead.

Yes, but the typical stock's dividend yield -- that is the annual payout as a percentage of the stock's price -- has become minuscule. In 2000, the average S&P stock paid a dividend that was just 1.1 percent of its purchase price -- the lowest figure in market history. This year, because the prices of S&P stocks took a big tumble, yields rose a bit -- but only to 1.4 percent, the third-lowest ever. For the past 60 years, yields have been dropping sharply. In the 1940s, they averaged 5.9 percent; in 1970s, 4.2 percent; in the 1990s, 2.6 percent.

Still, it's possible to find strong companies with decent dividends. Dow Theory Forecasts, a newsletter with a leaning toward such firms, recently listed eight stocks with yields of at least 2 percent and dividends that have increased by at least 45 percent over the past five years. They are Bristol-Myers Squibb Co., pharmaceuticals; Caterpillar Inc., construction equipment; Duke Realty Corp., commercial real estate; Emerson Electric Co., electronics; KeySpan Corp., natural gas distribution; Merck & Co., pharmaceuticals; Philip Morris Cos., cigarettes, beer, food; and Popular Inc., a Puerto Rican bank.

At a time when two-year Treasury notes are yielding about 3 percent, the yields of many of these stocks are enticing. For example, KeySpan last week declared a quarterly dividend of 44.5 cents per share -- or $1.78 for a full year. The stock closed Wednesday at $30.82, for a yield of 5.8 percent. Duke is a typical real estate investment trust, or REIT, which by law has to pass nearly every penny of its profits on to shareholders in the form of dividends. Duke's dividends this year are expected to total $1.80, and it trades at $23.83, for a yield of 7.6 percent.

But don't be deceived by REITs. On average, companies pay out about one-third of their profits in dividends, so, when bad times hit, they have a cushion. There's still cash to keep the dividend steady, and most conventional firms are extremely reluctant to cut their payouts -- it's a sign of terrible weakness. REITs, however, pay out 95 percent of their earnings, so, when business falls off, the dividend usually gets cut. It's wise, then, to check the REIT's past performance to see that it has a track record of rising dividends. In Duke's case, the record is superb: Dividends have increased every year since the company went public in 1993. By contrast, Crescent Real Estate Equities, a Texas-based REIT, currently yields a stunning 8.7 percent, but it was forced to cut its dividends in 1999, 2000 and 2001 -- not a good sign. In general, however, REITs offer a steady flow of cash.

What you do with that cash is up to you, but reinvesting it in more stock can pay off in spectacular ways. T. Rowe Price researchers calculated that if an investor who put $1,000 into the S&P 500 stocks in 1982 had accumulated $16,597 by 2001. But $7,100 of that gain came from reinvesting the dividends -- however puny -- the shares threw off. In other words, $2 out of every $5 ended up coming from dividends.

Some companies are true dividend heroes. Dow Chemical Co., for example, has paid a dividend every quarter since 1911. It's currently yielding 4.6 percent. Procter & Gamble Co., Minnesota Mining & Manufacturing, Johnson & Johnson Inc. and Genuine Parts Co. have each increased their dividends annually for at least 40 years. Tootsie Roll Industries Inc., one of my favorite companies, has boosted dividends for 37 straight years.

And don't forget that, as dividends grow over time, so does the annual return on your original investment. For instance, T. Rowe Price points out that if you had invested in Schering-Plough Corp. 20 years ago, your annual dividend today would amount to a yield of 63 percent on the money you first invested -- and that percentage will continue to rise. Last year's dividend payment from Philip Morris actually exceeded the stock's price 20 years ago, so an investor would be making an annual return of more than 100 percent on the dividend alone.

But don't get carried away with dividend-paying stocks. You can certainly do very well owning stocks that pay little or nothing to shareholders. After all, the No. 1 stock over the past 10 years -- Dell Computer Corp., up 7,800 percent -- pays no dividend at all.

Still, in times like these, you should want to see the money. Get in the habit of scanning lists of recommended stocks for companies that pay decent dividends. For instance, the Focus List of Raymond James Associates Inc., an investment firm with a strong track record for picking winners, includes Fannie Mae, the huge mortgage financier, currently yielding 1.6 percent; Chubb Corp., insurer, at 2 percent; and Stanley Works, toolmaker, 2.2 percent.

Of course, no dividend is guaranteed, but there's an excellent chance that a company's payouts will continue -- and grow. Two percent may not sound like much, but it's nice to have something to count on in a turbulent market.

Originally published in The Washington Post.
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