News & Our Thinking

October 3, 2010 (Dave Nicklaus)

The lowly dividend is back in favor.

Investors, who sneered at the quarterly checks during the bull markets of the ’90s and ’00s, have come to see dividends as a sort of comfort food. They help a person get through hard times, and they can provide a large part of the sustenance, or total return, that everyone needs.

Even technology companies have become converts. Microsoft shares, which paid no dividend until 2003, now yield more than a 10-year Treasury note. Cisco Systems, which long insisted that it had better uses for its cash, said last month that it would start paying a dividend.

The market is starting to look more like it did in the 1950s — when stocks regularly yielded more than safe assets such as Treasuries — than the go-go 1990s.

“Back in the ’50s, some of the blue chips like Coke were yielding 5 and 6 percent,” said Carl Enloe, an adviser at Monetary Management Group in west St. Louis County. “That was considered compensation for the risk you faced in the equity market.”

In the 1990s, investors and companies turned that logic on its head. Instead of wanting to be paid for the risk of holding stocks, they figured, you should be willing to accept little or no income because stocks had so much potential for capital appreciation. By 2000, the dividend yield on the Standard & Poor’s 500 index had shrunk to 1.1 percent.

Trouble is, capital appreciation proved illusory. After two severe bear markets, investors began to shy away from companies that had squandered cash by making ill-fated acquisitions or buying back shares at inflated prices. One way to regain investors’ confidence is to write them a fat quarterly check.

“If investors can’t see, touch and feel better earnings growth, they’re impatient, and they want to see a better dividend,” says Norman Conley, chief investment officer at JAG Advisors in Ladue.

At just under 2 percent, the S&P 500 dividend yield has nearly doubled in the past decade. It’s only half a point below the yield on a 10-year Treasury note. In 2000, the yield gap between stocks and Treasuries was 5 percentage points.

In other words, buy-and-hold investors are once again being paid for their patience.

“The stock market has had a lost decade, but at some point strong cash flows and a nice dividend yield become attractive to investors,” says Scott Harrison, senior analyst at Argent Capital Management in Clayton. “I think we’re at that point now.”

Of course, hopes for yield can prove futile if a company cuts or eliminates its dividend, as many did during the recession. Cash payouts by S&P 500 companies fell 30 percent between mid-2008 and early 2010, but have risen in the latest two quarters.

It’s dangerous to seek out the very highest-yielding stocks; those may be the companies at highest risk of cutting the dividend. One should study earnings and cash flow statements to make sure a company can still afford the quarterly checks.

That said, today’s market is filled with intriguing opportunities. Some blue-chip companies, such as Johnson & Johnson, offer a higher yield to stockholders (3.5 percent) than to bondholders (2.9 percent on a 10-year bond).

Over long periods, dividends contribute more than one-third of the stock market’s total return. In the past 50 years, the S&P 500 is up 6 percent a year based on price appreciation alone, but 9.3 percent when dividends are included.

Dividend-hungry investors face a political risk at the moment: Unless Congress changes the tax law, dividends will lose their special tax treatment on Jan. 1. They’d be taxed at ordinary income-tax rates, as high as 43.4 percent, instead of the current maximum of 15 percent.

President Barack Obama has proposed a 20 percent maximum tax on dividends, but it’s tied up in the broader issue of whether to extend tax cuts for the wealthy. If rich folks do end up facing a much higher tax bill, they could lose their appetite for dividend-paying stocks.

Stuart Freeman, chief equity strategist at Wells Fargo Advisors, thinks that risk is already built into stock prices. “The market has been thinking about that all year,” he says.

Freeman sees other reasons why the next year or two may be good to dividend-seekers. “They were knocked down during the recession,” he says. “As things slowly get better, a lot of companies will reinstate dividends as they feel more confident about the recovery.”

For investors who came of age in the growth-crazed 1990s, investing for dividends may seem a bit fogey-ish. After a lost decade in the stock market, though, thinking like Grandpa looks like a pretty smart move.