TCS Daily

Stocks Can Mean Cash

By James K. Glassman - June 26, 2003 12:00 AM

The stock market has been rising impressively, but practically all I hear these days are complaints about low interest rates. Readers lament that they can make only three-quarters of a point in a money-market fund such as Merrill Lynch Ready Assets, or just 1.3 percent with a double-A-rated two-year corporate bond.

Stop whining! Low interest rates are good news. They reduce the cost of borrowing, and they are setting the stage for an economic recovery that could be powerful. Economist John Makin, my colleague at the American Enterprise Institute and a grumpy bear for the past three years, sees low interest rates persisting through 2006 at least, and, partly as a result, he is predicting that the gross domestic product, now growing at less than 2 percent, will "rise to 4 percent and probably overshoot to 5 percent for one or two quarters in 2004." A booming economy is very, very nice for stocks.

Still, I understand the gripes. Some people need income -- a steady flow of cash to live on -- and they can't find it among the usual suspects, such as money-market funds, certificates of deposit and short-term bonds.

There is, however, another place to look: the stock market. The average stock among the 30 components of the Dow Jones industrial average is now yielding 2.1 percent -- about the same as a five-year Treasury note. That compares with an average of 1.8 percent between 1997 and 2002. Shares of ChevronTexaco (CVX), for example, are yielding 3.8 percent -- half a point more than a 10-year T-bond. Such tasty dividends are unusual in recent market history. Gobble them up.

Dividends are the portion of profits that a company bestows each year, in quarterly installments, on its shareholders. Different firms have different policies; many don't pay dividends at all. But with the recent tax cut, stocks that offer decent dividends are looking even more attractive. The tax rate on dividends has been sliced to just 15 percent, so when you receive a payout of $100 today, you get to keep $85 after federal taxes, instead of as little as $61.40 last year. (Interest on bonds, by contrast, is taxable at the same rate as your salary -- up to 35 percent.) There's no doubt that the tax cut has helped lift stock prices, as most economists expected, but my hunch is that we haven't seen the full effect of the dividend-rate reduction on the market quite yet. The cut will induce more companies to boost their quarterly payouts -- or, in some cases, initiate them. And small investors will start realizing that dividends (which have declined in importance over the past two decades) are actually desirable and will bid up stocks with good yields.

One indication that investors still don't care much about dividends is that it is difficult to find a premium mutual fund with a high yield. One reader presented me with that challenge last week, and all I could come up with were these: American Funds Washington Mutual Investors (AWSHX), which last week owned a stock portfolio that was yielding 2.1 percent; American Century Equity Income (TWEIX), 2.3 percent; and Vanguard Equity-Income (VEIPX), 2.4 percent. These rates, of course, aren't fixed, but they probably won't change much during the year.

Even yielding a shade over 2 percent, the three funds, each with relatively low levels of risk, are attractive alternatives to bonds. And among their assets are stocks with truly mouthwatering dividends.

Among the top holdings of Washington Mutual Investors, a magnificently stable fund about which I rhapsodized a year and a half ago: J.P. Morgan Chase (JPM), 3.8 percent; General Electric (GE), 2.4 percent; and Bristol-Myers Squibb (BMY), 3.9 percent. Large holdings in the American Century portfolio include Kimberly-Clark (KMB), paper products, 2.5 percent; BP (BP), energy, 3.3 percent; and SBC Communications (SBC), telecom, 4.4 percent. The Vanguard portfolio is headed by Exxon Mobil (XOM), 2.7 percent; Verizon Communications (VZ), 3.9 percent; and Bank of America (BAC), 3.2 percent.

As you can see from the list, high dividend payouts tend to be concentrated in the financial, drug, energy and utility sectors. Many industrial and natural resources companies also pay good dividends. (Real estate investment trusts, with even loftier yields, are a special case; they have long enjoyed privileged tax status if they distribute nearly all their profits, but they get no new benefits from the recent tax law.) Service firms, including retailers and restaurants, and high-tech companies are less likely to distribute their profits to shareholders, but that could change.

On June 13, Mandalay Resort Group (MBG), a company that runs casinos and hotels in Nevada and Mississippi, announced it would pay a dividend for the first time -- 92 cents a year. The stock immediately shot up 11 percent, and it now carries a dividend yield of 2.7 percent.

Recently, Microsoft (MSFT), the world's largest software company, started paying a small dividend -- 8 cents a share, for a yield of 0.3 percent. Microsoft has zero debt, and it's sitting atop a huge pile of dough -- about $50 billion. That's 11/2 times the software company's annual revenue and about $5 for every share of stock. The business generates so much cash (more than $1 a share each year) and has to spend so little on capital investment for buildings and machines (typically less than 10 cents) that it appears almost certain the dividend will rise.

A company with a fairly steady stream of cash and modest capital needs can easily send about half its earnings to shareholders in the form of dividends. Mandalay, for instance, is starting off with a 40 percent payout ratio. Many companies have ratios far below 50 percent, however, so there's lots of room to increase their regular outlays to investors.

Citigroup (C), for instance, last year had a payout ratio (dividend divided by earnings) of just 29 percent; MBIA (MBI), the bond insurer, had a ratio of 17 percent; Expeditors International (EXPD), a well-run shipping company whose stock has more than tripled in the past five years, just 11 percent; and Adobe Systems (ADBE), which makes Acrobat and Illustrator software, a mere 5 percent. Adobe has no debt, $650 million in cash and minimal capital-spending requirements. Its 5-cent dividend, last increased in 1993, accounts for a yield of only 0.1 percent.

Why hasn't Adobe been sending more of its profits to shareholders? Perhaps because the shareholders haven't asked. After all, Adobe's earnings are taxed at the corporate level at 38 percent and the part of the remainder that was distributed as dividends was taxed last year at another 38.6 percent (in the case of top-bracket investors) plus state taxes. So Adobe hung on to its profits or used them to buy back stock -- a way to raise the value of the outstanding shares without immediate tax consequences for shareholders.

But now, with lower tax rates, the old cash-hoarding policy could change. If it does, investors will benefit, not just from the extra cash but from greater transparency. Dividends are the best manifestation of corporate health because they're hard to manipulate. "Earnings are opinion," goes the old saying, "but cash is a fact."

Also, while companies don't promise to maintain their dividends year after year (as bond issuers do with interest payments), firms are extremely reluctant to reduce their payouts. Yes, dividends get cut, but, in general, you can rely on them. Finally, dividends enforce management discipline. Too much cash flowing into the corporate treasury can lead to laziness and mistakes, as recent academic research has shown. "Companies that don't pay dividends," wrote Peter Lynch in "One Up on Wall Street," "have a sorry history of blowing the money on a string of stupid diversifications." Let managers give their shareholders the profits; then let the managers try to persuade the shareholders to reinvest those payouts with the company.

In addition to tax treatment, the big advantage of a stock dividend over a bond interest payment is that the dividend tends to rise over time. Say that you pay $100 for a stock that pays a $2 annual dividend, and that the dividend rises an average of 7 percent a year. Within about 10 years, the dividend will be $4; in another 10 years, $8. This is no theoretical exercise. Merck (MRK), the drug giant, paid a dividend of 14 cents in 1987; last year, after rising annually and steeply, Merck paid $1.41.

What about the here and now? The Buy List of the Dow Theory Forecasts newsletter includes such generous dividend payers as Arthur J. Gallagher (AJG), insurance brokerage, at a yield of 2.5 percent; ConocoPhillips (COP), energy, 2.9 percent; and Altria (MO), tobacco and consumer products, 6 percent.

Elliott Schlang, whose Great Lakes Review research service finds sound, boring, growing companies based in the Midwest, is enthusiastic about RPM Inc. (RPM), which makes coatings such as Rust-Oleum and Varathane, plus DAP caulks and Testors glue for putting together model airplanes. "Dividends have increased for 29 consecutive years," writes Schlang. The stock yields 3.8 percent, with a payout ratio that's slightly under half of earnings.

The Value Line Investment Survey recently highlighted FPL Group (FPL), which provides electricity to 8 million customers in Florida and other East Coast states and yields 3.6 percent. Value Line also maintains a model portfolio of stocks with both robust dividends and good price-appreciation potential. Among the standouts: General Mills (GIS), food processing, at a yield of 2.2 percent; Sherwin-Williams (SHW), paints, 2.1 percent; BB&T Corp. (BBT), banking, 3.2 percent; and Fortune Brands (FO), a mini-conglomerate that makes golf balls, wine and bathroom faucets, 2 percent. As the market has risen, the yields of all these stocks have fallen -- as numerators (dividend payments) have stayed the same and denominators (prices) have increased. But, again, expect those numerators to climb in the years ahead.

Other intriguing dividend payers to consider: General Motors (GM), which is yielding 5.1 percent; United Bankshares (UBSI), a West Virginia-based bank with a strong reputation, 3.3 percent; and Landauer (LDR), which monitors radiation exposure for industrial clients, 3.3 percent.

You can put together your own dividend-rich portfolio or buy one of the mutual funds I cited earlier.

Washington Mutual is among the best funds of any sort, having whipped the benchmark Standard & Poor's 500-stock index by an annual average of 3 percentage points over the past five years and holding losses to a minimum in bad times. The "A" shares carry a front-end load of 5.75 percent, but the effect of that commission dissipates over time, and the fund's annual expenses are only 0.65 percent (also, minimum investment is a mere $250).

Vanguard Equity-Income has produced similar returns since 1998, with no load and expenses under half a percentage point. But its performance over the past 10- and 15-year periods has trailed that of Washington Mutual.

American Century Equity Income, launched in 1994, has the best medium-term record of the three, with average annual returns of 9.3 percent since June 1998 -- and at risk levels that Morningstar characterizes as "low." The fund concentrates on mid-cap value stocks, so you could buy it in tandem with the Washington or Vanguard fund and get a diversified dividend-paying portfolio. (It's hard to find good high-yielding small-caps.) The only drawback of using stocks instead of bonds to produce income is that the risk is higher in the short-to-medium term. With a Treasury bond, you're assured of a fixed rate of interest and the return of your principal. You don't get that with stocks, but you do get higher rates, better tax treatment and a good chance that the payouts will rise. The choice is yours.

Last week's column contained an error in the description of a puzzle from John Allen Paulos's book "A Mathematician Plays the Stock Market." The challenge is to guess a number from 1 to 100 (not 1,000) that is 80 percent of the average number chosen by others in a group. As participants keep guessing and second-guessing, the eventual optimal answer is zero, the Nash Equilibrium.


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