The prospect of tax-free dividends, as proposed by President Bush, has increased the attention paid to dividend-paying stocks. How can you find stocks likely to reward you with a mix of dividend income and future capital gains?
Look for stocks that now pay significant dividends. In early 2003, the average dividend yield on the stocks in the Standard & Poor’s 500 Index was 1.75 percent. Thus, you probably should aim for stocks yielding over 3 percent, and certainly over 2 percent.
Invest in companies that have a history of increasing their dividends. Some companies have steadily raised their dividends, year after year. Not only will this gradually boost the yield on your original outlay, investing in such stocks means that you’ll own companies that regularly enjoy expanding cash flow from operations.
Avoid those companies with the highest dividends. More yield often equals more risk. A high yield may indicate the market has doubts about a stock, which could lead to a capital loss. Earning a 7 percent or 8 percent dividend won’t please you if the stock price drops 10 percent or 20 percent.
Look for a low “payout ratio,” the relationship between a company’s dividend and its earnings. A high dividend is vulnerable to being cut, which is likely to depress the trading price. If a company’s payout ratio provides a cushion of at least 20 percent, the risk of a dividend cut is reduced. For example, a company earning $1 a share should be paying no more than 80 cents in dividends.
Where can you find companies with substantial yet relatively safe dividends these days, companies that might reward you with higher dividends and higher stock prices, over time?
Regional banks. Banks are watched closely by the government so they don’t have accounting scandals. Compared with major banks, regional banks are less exposed to global problems.
Insurance brokers. Successful brokers don’t take the risks of insurance companies–they just sell insurance and receive commissions.
Salute the “Generals.” General Electric, which pays a dividend over 3 percent, is out of favor as a growth stock because its earnings aren’t growing at 15 percent per year these days. However, with earnings growing at 9 percent now, it’s still attractive as a dividend-paying stock. At General Motors, the dividend is around 6 percent and there may not be a great deal of downside risk in the stock.
Run with the “Dogs of the Dow.” Historically, investors have done well by buying the 10 stocks in the Dow Jones Industrial Average with the highest dividend yields. Currently, those include Philip Morris, J.P. Morgan Chase, GM, and Eastman Kodak.
