Dividends Are Back

Stocks that pay dividends, out of favor in the '90s, are now back in vogue. There are several reasons for this change, including last year's tax cut and the desire of investors for more stable (if less spectacular) returns on their investments.

If you don't already own dividend-paying stocks, this may be a good time to consider adding them to your portfolio.

What are dividends?

When a company is making money, it can either share some of that profit with its shareholders in the form of dividends or put all of the money back into the business to help it grow.

Around 1970, two-thirds of U.S. corporations paid dividends to their shareholders. Investors regarded dividends as another way to earn a return on their investment. They felt that companies that paid dividends were strong and confident about their future. At the same time, eliminating or reducing dividends was seen as a sign of financial weakness, so once a company decided to pay dividends, they were making a commitment to continue those payments.
By 1999, however, only about one in five companies was still paying dividends. What happened in those three decades?

Why dividends declined

The heavy tax bite on dividends was probably the biggest reason for the change. When corporations pay a dividend, they pay it with net income -- money that's already been taxed once at the rate on corporate profits. Then, when the individual stockholders receive the dividends, they have to pay tax on that money again, at their ordinary income tax rate.

That double taxation made a significant impact in the amount a stockholder actually received. Until last year, when the tax law changed, the government took about 60 percent of every dividend dollar. Suppose a company had a $100 profit and wanted to pay that out to a shareholder. The government would claim $35 of that $100 right off the top, so the shareholder actually would receive a dividend payout of $65. That amount would then be taxed at a rate of 38.6 percent for stockholders in the highest tax bracket. That left just $39.31 out of the original $100 profit for the investor.

Another reason for the decline in dividends was the nature of the companies that prospered during the 1990s.

Older, more stable companies -- the gas and electric companies, the Procter & Gambles -- are the ones that usually pay dividends. These companies have passed their explosive growth stage and have moved into a period of smooth, steady (if less spectacular) expansion. They usually don't have as great a need as younger companies to reinvest all their earnings in plants and equipment -- and have less opportunity to reinvest in assets with good potential returns. 

The hottest companies during the 1990s, however, were young start-ups, most often tech companies that needed to reinvest their profits to grow. They didn't pay dividends, because they had other, better uses for their money.

Plus, with stock prices increasing so dramatically, companies that reinvested their money back into the business were getting a much larger return on that investment than an individual stockholder could hope to achieve.  It didn't make sense to pay out dividends under this scenario. 

Tax cuts rekindle dividends

Then came the stock bust. After suffering through a negative market for three years, investors began to think that it wouldn't be so bad, after all, to have some dividend income to bolster their portfolios.

One lesson they learned in the downturn was that start-up companies, while enjoying high initial returns, are very volatile and can end up going off a cliff. Companies that pay dividends, on the other hand, may show less impressive short-term gains but are more consistent over the long term.   

President Bush's tax cut helped spur a return to dividend-paying stocks. While the legislation passed by Congress last year did not entirely do away with the double taxation of dividends, it did reduce the tax bite substantially. 

For dividends received beginning January 1, 2003, stockholders in the 10 percent and 15 percent tax brackets must now pay just 5 percent in taxes. Taxpayers in other tax brackets now pay 15 percent. (There are some limitations on which dividends qualify for the new rate; keep reading for more specifics.)

In pushing for the reduction on dividends, the president and his economic advisors hoped a number of good things would happen. They wanted to encourage investors to buy more stocks. They also wanted people to have more money in their pockets to purchase goods and services to jump-start the economy.

I believe the strategy worked. Last year's stock market gain -- 28 percent for the S&P -- was larger than the 18 percent many analysts expected. Investors put their money back into the market instead of paying it to the government.

When investors put more money back into stocks, corporations have more money to invest in their operations, leading to economic growth and more jobs. Like many other tax cuts passed by Congress, this dividend tax relief is temporary (at least so far). Taxes on dividends will revert to taxpayers' ordinary income tax rates in 2009. (The hope of the Bush administration, of course, is that the tax cuts will prove so beneficial to the economy that Congress will see the wisdom of extending them further, or even eliminating taxes on dividends altogether.)

Stabilizing the market

During the 1990s, investors focused on growth stocks -- those with high earnings per share, with higher-than-average price-to-earnings ratios, with small (if any) dividends, and with greater volatility. Now the pendulum is swinging back to blue-chip stocks, with their lower but more consistent returns -- and with greater emphasis on dividends as a part of their total return (dividend plus capital appreciation).

In the past two years, more companies have climbed onto the dividend bandwagon.  Merrill Lynch reports that in 2003, 416 companies within the Standard & Poor's 1500 increased their dividend payment, and 32 started making dividend payments. In 2002, 398 of those companies increased their dividends, while 13 started making them.

Some analysts believe the emphasis on dividends will help increase the overall stability of the market. As investors demand dividends, the pressure will be on companies to focus more on long-term growth rather than short-term returns. Faced with a need to return money to shareholders, managers may use the money that they reinvest in the company for higher-quality, more carefully considered projects.

How you can benefit

Dividend-paying stocks can also add more stability to your own portfolio -- and you probably won't be sacrificing your long-term returns. From 1926 to 2001, 43 percent of the returns on large company stocks have come from dividends.

But don't make the mistake of buying such stocks based solely on the size of the dividend they are paying. Remember the fundamentals: Look for companies that have a past record of careful growth and then ask if you believe that management can take their products and services into the future with the same success.

Make sure you understand all the ins and outs of the tax regulations. For example, to qualify for the reduced tax rates, the dividends must come from a domestic corporation or a qualified foreign corporation. Interest from bond and money market funds (which are sometimes called dividends) don't qualify. Neither do dividends from real estate investment trusts, credit unions, savings and loans, cooperatives, and mutual insurance companies. Dividends paid to mutual funds by stock companies can be passed to the fund's shareholders as qualified dividends, but bond interest and other interest paid to such funds does not qualify.

You must also hold the dividend-paying stock for at least 60 days before the stock's "ex-dividend" date.  That's the date by which you must hold shares in order to receive an upcoming dividend.

Trevor 'Chip' Lewis Jr., CFP, is Managing Director of PSA Financial Center Inc. in Lutherville, Md. He was designated one of the Top 250 Financial Planners in Worth magazine in 2001, and the Top 150 Best Financial Advisers for Physicians in Medical Economics in 2002. Among other professional organizations, Mr. Lewis has been active in the leadership of the National Financial Planning Association and the National Association of Planned Giving. He can be reached at chip@psafinancial.com or via editor@physicianspractice.com.

This article originally appeared in the May 2004 issue of Physicians Practice.