Is Your Portfolio Paying Enough Dividends?

Most of the news about dividend-paying stocks during the first half of the year focused on the oil spill in the Gulf of Mexico. When BP suspended its dividend to brace itself for the costs and responsibility associated with one of the worst environmental disasters in U.S. history, investors were reminded again of the importance of maintaining a diversified investment strategy.

Behind the headlines, though, a more upbeat dividend-paying story has quietly been unfolding — this group of stocks as a whole has emerged as something of a hedge against recent market volatility. "Dividend-payers are typically high-quality companies with robust cash flows and solid balance sheets," says Ash Rajan, Head of Investment Policy, Investment Management and Guidance for Merrill Lynch. And at a time when yields on short-term bonds have sunk below 1%, dividend stocks can potentially provide a robust and relatively liquid source of income. "All these factors just make them very attractive," he says.

There's a common perception that dividend-paying stocks are best suited to conservative investors or those in or nearing retirement. They can use some of the income they might otherwise deploy for fueling growth to reward shareholders, companies that pay dividends "haven't gone up as much in the good times," observes Howard Silverblatt, senior analyst at Standard & Poor's, "and, in general, they historically haven't gone down as much in the bad times. The dividend can often act as a kind of anchor, holding the stock relatively steady."

But it would be a mistake to equate these stocks' lower rates of appreciation with lower returns. That's because the most sought-after dividend-paying stocks have the potential to pay investors in two ways: through capital appreciation and yield.

Compounded over many years, the multiplier effect of this "double dividend" on a portfolio can be profound. Silverblatt notes that during the past 31 years, dividend-paying stocks in the S&P 500 have outperformed S&P non-dividend-paying stocks by an average annual rate of 1.48%. Savita Subramanian, Head of U.S. Quantitative Strategy for BofA Merrill Lynch Global Research, points to an even more surprising fact: "Since the inception of the Nasdaq in 1971 as the place where most high-growth tech stocks are traded, the total return of the S&P Utilities Index, which is generally composed of more conservative dividend-paying stocks, has outperformed the total return of the Nasdaq."

Will higher taxes offset the benefits?

To be sure, the most significant headwind for dividend-paying stocks came during the recent economic downturn. Last year, in an effort to shore up their balance sheets, more companies cut their dividends than at any other time in history. "It was an unusually bad time — reducing a dividend by a significant margin is quite a rare event," says Subramanian. Still, even that tough stretch could pave the way for healthier dividends in the quarters ahead. "Corporate cash balances are higher than ever," she explains. "In an improving economy, we expect more companies may use the cash they've stockpiled to increase dividends to court yield-seeking investors."

In fact, if there is a cloud hanging over dividend-paying stocks, it may have less to do with market dynamics or the mounting disaster in the Gulf than with the fiscal storm gathering in Washington, D.C. In 2003, President George W. Bush lowered the tax on qualified dividends (dividends on shares held by the shareholder for at least 60 days before and after the dividend issue date, or 90 days for preferred stock) to 15%, the same rate as the capital gains tax. Now that those cuts are scheduled to expire at the end of 2010, qualified dividends are slated to be taxed again at the same rate as ordinary dividends and all other forms of ordinary income. With ordinary income rates for top earners set to rise to 39.6% (and to 44% when a new health care surcharge takes effect in 2013), that would mean a near tripling of the dividend tax rate in the next three years.

The White House has backed capping the hike on the qualified dividend tax rate at 20%, so there is at least a chance that dividend-paying stocks could continue to maintain their tax advantage over other forms of investment income. If they don't, though, one option for maintaining a similar exposure and favorable tax treatment may involve reallocating some holdings to shares in high-quality, yield-bearing master limited partnerships (MLPs). Common in the energy infrastructure sector and listed on the same exchanges as many dividend-bearing stocks, MLPs enjoy a tax designation different from corporations. That, in turn, allows shareholders to treat a substantial portion of their dividend income as return on capital, with the taxes not coming due until the asset is sold.

There are other factors that add to MLPs' appeal. Up-front yields have been trending higher than even those of many comparable dividend-paying stocks, and as of late June, for example, share prices for the Energy MLP Index were up approximately 10% for the year. "Even without the tax changes, we think MLPs have a lot going for them right now," says Gabe Moreen, Natural Gas Analyst at BofA Merrill Lynch Global Research.

Understanding yield

When analysts like Moreen talk about "yield," technically they are referring not to a stock's dividend but to its dividend divided by its share price. High yield, therefore, doesn't always reflect high quality. Higher yields can occur, for example, when a company is in trouble and its stock price has plummeted. On the other hand, when combined with strong underlying fundamentals, a high yield may indicate that the stock is temporarily undervalued and "has the potential to render capital appreciation while the investor gets paid a dividend to wait," says Rajan.

That is why it's important for investors to be particularly selective when looking for the right dividend-paying stocks for their portfolio. "You shouldn't simply be invested in a category," says Rajan. "You need to pay particular attention to the overall strength of the dividend-paying company." For that reason Merrill Lynch regularly screens for high-quality companies with strong fundamentals and competitive yields for its Financial Advisors and clients.

Another popular screen for the highest-quality dividend payers: the Dividend Aristocrats. This is an annual list of S&P 500 dividend payers that have increased their dividends for at least 25 consecutive years. With 7,000 baby boomers hitting retirement age every day and potentially looking for income-producing investments, Subramanian says she wouldn't be surprised if such screens increasingly become some of the market's most closely watched barometers. "The great irony is that in the past, investors tended to overlook dividend stocks because they weren't flashy growth stocks," she says. "Now the imbalance between supply and demand could mean high-dividend-yielding stocks command a lot more attention."