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Time right to harvest dividends

©Washington Post
September 1, 2002

WASHINGTON -- A big story in recent years has been the dwindling dividend yield, that is, the percentage of a company's stock price represented by its dividend. At the end of 1999, the yield on the average stock in the Dow Jones Industrial Average hit an all-time low of 1.47 percent, following a steady decline that began a quarter-century ago when yields were around 5 percent.

But the latest figures show that the Dow on Aug. 16 was yielding 2.12 percent; that's a gain of more than half since 1999. Even a year ago the Dow was yielding just 1.75 percent. The average yield for the stocks of the broader Standard & Poor's 500-Stock Index recently was 1.69 percent, an increase of one-fourth over last year.

The good news is that dividends are back, and every investor should pay attention. I recently calculated the yield on the 30 individual Dow stocks by dividing the price of each into the dividends it paid over the past 12 months. Fifteen were yielding more than 2 percent, and seven of those were yielding more than 3 percent. In normal times, 2 or 3 percent sounds pretty paltry, but not today, with interest rates the lowest in a generation.

Compare, for example, the 2.1 percent yield on the Dow with the 2.2 percent yield on two-year U.S. Treasury notes. Meanwhile, Dow component E.I. Du Pont de Nemours, the giant chemical company, was yielding 3.4 percent, and Caterpillar, the world's largest maker of construction equipment and also part of the Dow, was yielding 3.1 percent.

In other words, if you invested $10,000 in Caterpillar today, you would receive (if the payout stayed the same), $1,700 in dividends over the next five years. If you invested in five-year Treasury securities, you would receive the same $1,700. With Treasuries, of course, you are guaranteed to get your original $10,000 back at maturity. But with Caterpillar you are likely, though certainly not guaranteed, to get back more. The typical stock has historically appreciated at about 8 percent a year. If Caterpillar rises at just 5 percent annually, your $10,000 worth of stock would grow to $12,800. In addition, Caterpillar's dividend should increase. Figure a modest 4 percent annually. Final tally of income and capital gains: Treasury note, $1,700; Caterpillar, $4,600.

To put it simply: If you invested in a portfolio of Dow stocks, you would be getting the same annual income as you would with two-year Treasury notes, plus the prospect of capital gains and rising dividends. This near-parity between stock dividend and short-term bond yields is a very attractive situation, and a highly unusual one over the past several decades. More typical was 1986, when the Dow was yielding 3.5 percent and two-year Treasuries were yielding 6.9 percent.

Using data from the Federal Reserve going back to 1976, I could not find a single year in which two-year T-notes were not yielding more (in most cases, substantially more) than the Dow. Currently, rates are within a tenth of a percentage point of each other. The next-best year was 1993, when T-notes yielded an average of 4.1 percent and the Dow yield was 3.1 percent.

But even juicier than the high yields for the Dow as a whole are the slightly lower yields provided by most consistent Dow performers. Consider Procter & Gamble, which has increased its dividend annually for more than 40 years. In 1998 and 1999, P&G's annual dividend yield was 1.3 percent; recently it was 1.8 percent, the highest since 1996. Coca-Cola, another Dow company that has been boosting its dividend each year for decades, was yielding 1.5 percent, compared with just 0.9 percent in 1997.

The environment for solid dividend-paying stocks has improved for three reasons:

First, stock prices have dropped, and since yield is dividend divided by price, a sharply falling price means a sharply rising yield. At one point in 1998, for instance, Coke traded at $88 a share and paid a dividend of 60 cents; that's a yield of only 0.7 percent. Recently Coke closed at $52 and paid a dividend of 76 cents over the past 12 months, for a yield of 1.5 percent.

Second, dividend payouts keep increasing. Companies are extremely reluctant to lower their dividends, even if profits fall. At Coca-Cola, for instance, profits dropped from $4.2-billion to $3.5-billion in 1998, but Coke increased its dividend anyway, from 56 cents to 60 cents per share. Coke, like most companies, had plenty of cushion since it distributes only one-third to one-half of its annual earnings to its shareholders. In 1997, the payout ratio (dividends divided by earnings) was 34 percent; in 1998, it rose to 42 percent, still providing a margin of safety.

Third, interest rates in general have plummeted as the economy has slowed and inflation, over the long term, has been reduced, because of better stewardship by the Fed and a rising supply of goods produced at home and abroad. Five-year Treasury rates went from 11.5 percent in 1980 to 8.4 percent in 1990 to 6.2 percent in 2000 to just 3.4 recently.

Dividends were neglected -- and even derided -- by investors during the 1990s. After all, with flashy nondividend paying companies such as Oracle and JDS Uniphase soaring in price, who needed quarterly checks in dribs and drabs? In addition, the tax bite is brutal. Since dividends are taxed at the corporate and the personal level, the government's take can be as much as 60 percent on the profits used for the payout. So it's not surprising that the proportion of companies that pay no dividend at all has hit an all-time high (about one-fourth of stocks).

But a bear market, along with falling interest rates, is making dividend payers very enticing for their yields and for their record of stability and value. Dow Theory Forecasts newsletter points out, "Since the tech sector began imploding in 2000, dividend-payers have beaten the rest of the market by 44 percentage points."

Finally, a dividend is the best evidence of a company's financial health. At a time when investors are skeptical of the revenues and earnings that corporations are reporting, dividends can give them confidence.

"Cash dividends force discipline on companies, especially in allocating capital resources," writes Edwin Everett of David L. Babson & Co., a value-oriented Cambridge, Mass., investment company. "If the past few years suggest anything, it is that corporate America needs more discipline."

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