Tax-law changes earlier in 2003 cut the dividend tax rate to 15%, matching the new rate on capital gains. Cash bonuses, unlike dividends, are still taxed at ordinary income rates, which could be as high as 38.6%. So these days, raising dividends has become a cheaper way as far as taxes are concerned to give company execs, who are often major shareholders, a bundle of cash.
"Keep in mind that a lot of these companies have large insider positions," says Joseph Lisanti, editor-in-chief of S&P's newsletter The Outlook. "Increasing dividends gives companies a way to lower the tax on bonuses and silence the corporate-governance types."
BUYBACKS, BYE BYE. That doesn't mean ordinary investors aren't benefiting -- even from the tax angle. When dividends were treated as ordinary income, companies were more likely to use cash for share buybacks -- a way to boost stock prices and increase returns. Now, though, "there's no longer the argument that it's more efficient to repurchase shares," says Richard Moroney, portfolio manager for Horizon Investment Services in Hammond, Ind., and editor of financial newsletter Dow Theory Forecasts.
What's more, Lisanti says, when dividends are issued, it tends to limit the cash available for what he calls corporate "hanky panky." "Companies can't go out and buy a widgetmaker they think would fit with their aerospace business but really doesn't," Lisanti says. "It can impose discipline on a company."
That doesn't mean investors should rush out to buy any old company that issues a dividend. Over time, dividend payers -- which are often banks, energy outfits, drugmakers, and consumer-staples companies -- have been solid investments. Since the end of 2001, the 366 dividend payers in the benchmark S&P 500-stock index have gained a respectable 6% through Oct. 6. By contrast, the index's 134 nonpayers declined 2.9% during the same period, much of which was a bear market.
TECH, TOO. Yet this year, dividend-payers have underperformed, as the rally has been led largely by dividend-averse Internet and tech names that survived the dot-com meltdown. Through Oct. 6, these outfits surged 48.7%, vs. a 20.5% rise in the dividend payers. The picture could change as a market-leadership shift under way appears to favor stable companies, often traditional dividend payers, investing experts say. "A rotation back to companies with stable earnings is how we see things," says Moroney.
Still, if you're thinking only Old Economy stocks issue dividends, think again. Technology outfits, which used to plow extra cash back into their businesses, are also starting to go the dividend route. Just look at Qualcomm (QCOM
). The wireless-chip giant launched a 5-cents-a-share dividend in March and raised it to 7 cents in July. And software behemoth Microsoft (MSFT
), long criticized by shareholders for sitting on its $49 billion pile of cash, recently announced it would double its dividend to 16 cents a share, after launching its first ever payout earlier in 2003.
"There is more pressure to spend the money wisely," says Chuck Carlson, editor of DRIP Investor, a newsletter about Dividend Reinvestment Plans (or DRIPs) based in Hammond, Ind. "In Microsoft's case, they are in effect saying 'We're not finding enough growth opportunities, which is why we're going to give some money back to investors.'"
EYE ON EARNINGS. The emphasis on dividend stocks has extended to the mutual-fund industry. The newly launched Alpine Dynamic Dividend Fund (ADVDX
) seeks stocks that offer gains in both stock-price appreciation and income. "We want companies that benefit from earnings growth as well as provide big [dividend] income," says Sam Lieber, president of Purchase (N.Y.)-based Alpine Funds.
A track record of dividend growth shows management's confidence, but sustained earnings growth is important, too. "You don't want to be buying companies that have good dividends but bad earnings," Moroney says. "Without the earnings, there's also a chance the dividends may dry up."
Moroney suggests looking for companies with solid dividend yields -- the annual dividend divided by the stock price. As a general rule, stocks with dividend yields greater than those for the major stock indexes -- the S&P 500's dividend yield is now 1.7% -- are the ones stock-pickers believe could outperform in the near term. Typically, dividend yield is calculated at the price that the stock is purchased.
GAINING TRACTION. One stock S&P's Lisanti likes is Bank of America (BAC
), which has a dividend yield of 3.9% for those who purchased it in early October. The financial-services giant has a history of increasing its dividend and carries S&P's highest ranking of 5 STARS, or buy. Other dividend payers S&P recommends include soft-drink company PepsiCo (PEP
) and drugmaker Pfizer (PFE
Clearly, the dividend trend is gaining momentum. Still, "a lot of companies are going to be slow to change," Lisanti says. The number of dividend hikes -- while up so far this year -- remains 8% less than the 10-year annual average. Complicating matters, the law that lowered dividend tax rates is set to end in 2007, leaving their future in question.
For now, though, a recovery in corporate profits is "emboldening more companies to raise dividends," says Carlson. Combined with the lighter tax burden, that means investors may end up with more cash -- to save, reinvest, or spend on shopping sprees. Wahlgren covers financial markets for BusinessWeek Online in New York