Dividends--Stocks' Secret Weapon

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During the high-growth 1990's bull market, interest in stock dividends dropped to near zero. But with the collapse of the tech bubble, there has been a growing appreciation for stocks which pay dividends. Nevertheless, dividends are still often undervalued by many stock investors.

Dividends are stocks' secret weapon. Studies show that dividends account for up to half of the total return of the stock market over long terms, a surprising fact considering how little publicity they get. There is no "Dividend Index" or anything like that which gets reported every day like the Dow and the NASDAQ.

Let's look at some facts about dividends.

• Not all stocks pay them. The payment of dividends is a discretionary decision made by each company's management and Board of Directors.

• But for companies that do pay them, dividend policies tend to persist. A company with a history of paying dividends will rarely abandon that policy. Many companies have been paying and raising dividends for decades, and there is no sign that they will stop.

• Dividend-paying companies tend to be larger and older companies, with well-established cash flows that fund the dividend each year. Thus, they tend to be companies that are more stable, safer, and less volatile. Many of them are quite simply cash-generating machines. They share some of that cash with you by paying it out in dividends.

• At the current maximum Federal tax rate of 15%, dividends are the most tax-advantaged form of income available. Better than your salary and better than bond interest (both of which are taxed at your marginal tax rate, which is usually higher than 15%).

• The best dividend-paying companies often provide significant potential for price growth on top of their dividends.

But the best thing about dividends is that your yield will often rise over time. Compare this to the fixed yield that bonds pay. This rising-yield phenomenon, to me, is the most intriguing aspect of dividend stocks.

How does the yield rise? It happens when the company raises its dividend. Many dividend-paying companies have a history--an implied policy--of increasing their dividend regularly. Often this is done in line with their earnings growth each year. So even a company with modest annual earnings growth of, say, 10% per year may increase its dividend 10% per year too. (In your job, how often do you get a salary increase of 10%?)

The increased dividend increases the percentage yield on your original investment. The math is simple. Say you purchase a $100 stock when its dividend yield is 3%. You buy 100 shares for $10,000, and the stock pays you dividends of $300 that first year. The next year, the company's earnings increase 10% and the company follows its usual practice of raising the dividend to match: Up 10% to $3.30 per share. You get paid $330. Your yield--calculated on your original investment--has jumped to 3.3%.

Note that it no longer matters what "current yield" is printed in the newspaper. That is based on the stock's current price, whereas your yield is based on what you invested. If the stock's price kept pace with its earnings growth (which is often the case), the current yield will still be depicted as 3%--but that only applies to new buyers, not to you.

If the 10%-per-year scenario keeps happening, in Year 3 your yield will be a little over 3.6%, in Year 8 it will have doubled from its original 3% to 6%, and in Year 16 it will be paying 12% on your original investment. That 12% yield exceeds the annual long-term return of the stock market itself, and far exceeds the fixed return available from any investment-quality bond.

Thus we see why dividends are stocks' secret weapon. They are underpublicized, yet provide about half the total return of the market with more safety. And they go up.

Unfortunately, ''income'' is often reflexively associated just with bonds. Many investors who are looking for income overlook the income available from stocks. But as we have just seen, stocks' income potential often exceeds that of bonds. The Sensible Stock Investor recognizes this and takes advantage of dividend stocks in his or her portfolio.

Now, of course, all these good things do not come without a little risk. Whereas most (certainly not all) bonds are relatively risk-free, stocks always have market risk attached. But given the large, mature, stable nature of many dividend-paying companies, that risk is relatively small. Dividend payers tend to be less volatile than the market as a whole, and certainly less than most high-growth stocks.

By the way, a high yield is not the only criterion for selecting good dividend stocks. A well-rounded approach will turn up stocks that not only have decent dividends to begin with, but also also the potential for price appreciation. In other words, the Sensible Stock Investor keeps his or her eye on total annual return--with a strong dividend component.

Happily, with the end of the bubble deflation in 2002 and the passage of the maximum 15% Federal tax rate on dividends, companies themselves--not only investors--are rediscovering dividends. More and more companies are paying them, and many companies which already were paying them have strengthened their payout rates. Overall, it is a good time to be a dividend investor.

Article Source: http://depositarticles.com/

Learn about a comprehensive stock approach that includes strategies for finding good dividend stocks. Sensible Stock Investing: How to Pick, Value, and Manage Stocks is a guide for the individual investor. Learn more about it at www.SensibleStocks.com . To go directly to Amazon.com, where the book has a perfect 5-star rating: www.amazon.com/gp/product/059539342X/sr=1-1/qid=1155381420/ref=sr_1_1/002-5852738-5260830?ie=UTF8&s=books .

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