April 25, 2012 / 5:03 PM / in 6 years

Navigating the dividend dilemma

NEW YORK (Reuters) - Once the domain of grandmothers waiting for a quarterly check from their local utility, dividends have become very appealing in the wake of a choppy decade for stock markets.

Traders work on the floor of the New York Stock Exchange, August 4, 2011. REUTERS/Brendan McDermid

Dividend-paying stocks reward investors whether the market goes up or down, a fact which boosted their popularity in 2011. Equity-income funds were the top diversified equity performers in 2011, up almost three percent for the year, according to fund research firm Lipper, a Thomson Reuters company.

But that popularity, ironically, could also be a problem.

“Dividend stocks have had a great run,” says Charlie Dreifus, senior portfolio manager of New York City-based The Royce Funds. “Has it become a crowded and overvalued space? Maybe.”

Companies jumping on the dividend bandwagon include Apple Inc AAPL.O, which, after years of rebuffing income-hungry shareholders, said recently it will award a quarterly dividend of $2.65 per share beginning in July.

Goldman Sachs Group Inc GS.N recently hiked its dividend for the first time in six years, by almost a third, making for a yield of roughly 1.6 percent.

Other dividend stalwarts offer even higher yields - like Merck MRK.N at 4.3 percent; Kraft Foods Inc KFT.N, at 3 percent; and Boeing Co BA.N at 2.4 percent.

The average yield of companies in the S&P 500 is around 2 percent, so you can own a broad index of equities and skim off as much income as you’d get from 10-year T-bills.

Historically, dividends have amounted to 41.85 percent of total stock market returns, according to data from S&P Indices.

CURBING ENTHUSIASM

But, investors, beware. With countervailing winds whipping around dividend stocks, are dividends still worthy of your adoration? Here are some channel markers to help you plot your course.

Pro - Boomers in search of income:

Every day for the next 19 years, about 10,000 Baby Boomers will turn 65, according to Pew Research.

As those 79 million Americans start to retire, they’ll going to need a steady stream of investment income to supplement their Social Security benefits. They’re not going to get it from money markets, which are averaging a measly 0.47 percent payout. And as governments around the world keep rates low to stimulate shaky economies, that low-yield environment doesn’t look to be changing any time soon.

That leaves dividend income from equities, which explains why so many Boomers are piling into the space, and propping up stock prices.

Con - Potential tax-code changes:

The attractive current tax rate of 15 percent on dividend income is set to expire at the end of this year. For those in the top tax bracket, that could mean a jump to a rate of 43.4 percent, a whopping 289-percent increase which could make dividend stocks decidedly less appealing.

“There’s just no way you can spin that as a positive,” says Royce’s Dreifus.

There are, however, some mitigating factors. First, there’s time for Congress to act on the issue, and a looming election will likely encourage them to keep taxes low. Second, roughly half of individual stock holdings are in tax-deferred accounts like 401(k)s or IRAs, for which current tax rates don’t matter all that much.

Pro - More diversity in the dividend space:

It’s not just utilities any more. Technology is now the second-biggest dividend payer, after consumer staples.

Con - Rich valuations:

Dividend stocks’ lofty valuations make continued domination of a dividend-oriented strategy unlikely. Telecom names in the S&P 500, for instance, are already valued at a pricey 18.4 times this year’s earnings, according to S&P Capital IQ, and utilities at a historically pricey 14.2.

PICK AND CHOOSE

Of course, your approach to dividend stocks doesn’t have to be all or nothing. Royce Funds’ Dreifus says the key is to be selective. Investors shouldn’t chase high yield alone, which can also be an indicator of a company in real trouble.

Instead, they should look for companies with a basket of positive attributes, of which the dividend is just one. Dreifus’s Holy Grail? A company that’s inexpensively valued, with a wide moat, predictable earnings, and enough free cash that it will be able to increase its dividend in future. He declined to name specific stocks.

“Sectors like consumer staples, utilities and telecoms are a little bit overvalued compared to their history,” says Ed Clissold, U.S. market strategist for Venice, Florida-based Ned Davis Research.

“But, over the long run, they’re not as overvalued as most people seem to think. And looking back over 40 years of data, companies that grow their dividends handily outperform those that don‘t.”

(The author is a Reuters contributor. The opinions expressed are his own.)

Editing by Jilian Mincer, Chelsea Emery and Bernadette Baum

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