Why a focus on dividends may merit consideration

December 1, 2006

Q My financial adviser has suggested that I invest in stocks that generate dividends even though I don't need any of the income my portfolio generates. If I'm going to work for another 15 years, shouldn't I be more concerned with long-term growth?

Q My financial adviser has suggested that I invest in stocks that generate dividends even though I don't need any of the income my portfolio generates. If I'm going to work for another 15 years, shouldn't I be more concerned with long-term growth?

The strategy of focusing on dividends went out of favor during the 1990s as more investors were drawn to fast-growing technology companies, which appeared to have great growth potential, but were incapable of paying dividends. Then in 2000, overvalued growth stocks, led by the technology sector, began a sharp decline that lasted over 2½ years. During this period, stocks that paid regular dividends held up relatively well, while the broad-based Standard and Poor's 500 Composite Index (S&P 500) lost almost half of its value. Investors decided that cash dividends were preferable to hopes of higher stock prices that sometimes never materialized.

From an income tax standpoint, the federal tax cut in 2003 significantly decreased the tax on qualified dividends from 35% down to a maximum tax rate of just 15%. Mutual fund income derived from interest, short-term capital gains, and dividends from certain non-U.S. corporations are considered "non qualified" dividends and thus do not qualify for the reduced tax rate. Recently enacted legislation extended the favorable 15% maximum tax rates on capital gains and qualified dividends through 2010. Investors certainly benefit as they are now able to retain 85% of the qualifying dividends, regardless of how high their regular tax bracket is. Since the tax cut was enacted in 2003, companies within the S&P 500 declared 587 dividend increases and more than 30 new dividends.

Overall, a growing dividend is very attractive, not only for the increased income, but also as a positive sign of a company's well-being and growth. Companies typically pay dividends only after accounting for operating expenses and internal growth plans. When a company has enough left over for shareholders, it's an indicator of healthy, positive cash flow.

It should come as no surprise, then, that a recent study of U.S. stock markets conducted by Ned Davis Research found that a portfolio of companies that initiated or increased dividends outperformed all others in the past 30 years. In the past 2 years, even some technology companies have begun to pay dividends to their shareholders. In December 2004, Microsoft paid its shareholders a special $3 per share dividend. It was the largest dividend ($32 billion) in stock market history.

While economists' views often differ on the direction of the financial markets, investors who focus on dividends don't have to rely on a strong market to see overall investment returns. Dividends represent a tax-advantaged income component that, while variable, offers the opportunity to enhance long-term returns.

Q It seems to me that most market movements are attributed to actions or remarks made by the Federal Reserve. Is the Fed really that powerful?

A The Federal Reserve is the independent central bank of the United States, composed of a Washington D.C.-based Board of Governors and 12 regional Federal Reserve banks. It is led by current chairman Ben Bernanke, who replaced longtime chairman Alan Greenspan. The chairman is nominated by the president and confirmed by the U.S. Senate.