Now May Be the Time To Dive Into Dividends

Summary: The steady stock performance of more conservative firms just seemed pale in comparison. But now, rising interest rates and slowing corporate earnings are causing investors to again turn to the tried-and-true: high-quality firms with strong cash flows, solid earnings and a healthy dividend stream.

Soaring technology stocks led the longest bull market in history during the 1990s, driving investors to shun stocks of dividend-paying firms. The steady stock performance of more conservative firms just seemed pale in comparison. But now, rising interest rates and slowing corporate earnings are causing investors to again turn to the tried-and-true: high-quality firms with strong cash flows, solid earnings and a healthy dividend stream. Companies that can commit to paying a regular dividend are ones that generally are fundamentally strong and optimistic about their future. A company's dividend history is a good indication of its willingness to share profits and demonstrate accountability to investors. In periods of market uncertainty, these qualities become especially appealing to investors. Stocks of companies that pay dividends generally have less price fluctuation than stocks of non-dividend payers. The dividend can create a cushion and smooth out a stock's price volatility. It's important to remember, however, that although dividend-paying stocks can add diversification to your portfolio and help minimize volatility, they still involve risk. The 2003 Tax Act added allure to dividend-paying stocks. It lowered the tax rate for individuals on qualified dividends from as much as 38.6 percent to just 15 percent, depending on your income tax bracket. This appreciation for dividends has spawned a renewed interest in mutual funds that pay dividends like the American Century Equity Income Fund (TWEIX), which has been investing in dividend-paying stocks for more than a decade. The companies in the fund typically are well-established and fundamentally strong, have steady earnings, a solid balance sheet and a history of paying dividends. The size of dividends also is on the rise. Three quarters of the companies in the S&P 500 Index pay dividends, and more than half of them increased their payouts during 2004. That's proof of a lot of strong balance sheets. A business has to have the earnings to pay a dividend and a strong balance sheet to increase one. Investors' preference for dividend-paying stocks is likely to continue, and so will the ability of many companies to continue paying dividends. Several years of economic uncertainty have driven companies to cut costs, reduce debt and rein in their capital spending. That means many of them now have a lot of cash on their balance sheets. This combination of lower debt and larger cash pools gives them the ability to increase dividends. Even with the current emphasis returning more cash to shareholders, the current dividend payout ratio is still below the historical average.