Beware Of Fat Dividends

Fast-growing Washington Mutual (WM) joined the swelling ranks of companies that are hiking dividends this year with back-to-back boosts in January and April. Bullish sign? Actually, it should set off alarm bells. The thrift, a big mortgage lender, is vulnerable to interest-rate hikes that have been casting a pall on the refinancing market. What's more, WAMU is spending heavily on expansion to open scores of branches across the country. So, hiking its quarterly dividend by first 2 cents a share and then by another penny, to $1.72 annually, seems puzzling. Sure enough, after rising about 5 a share earlier this year, to around 45, the stock has slipped below 39 as money managers have cooled to it. "Volatile," warns Charles Carlson, who heads Horizon Investment Services in Hammond, Ind.

For a lot of good reasons -- soaring earnings, a rise in confidence about the economy -- dividend hikes have swept across a broad swath of Corporate America. No doubt last year's tax cut, which reduced the bite on much dividend income to 15%, has combined with healthy cash flow at many companies to drive higher payouts. Some boards want to signal that the good times will keep rolling, and a strong dividend seems like such a promise. Others, especially in dividend havens such as banking, don't want to be the only ones not raising dividends.

But investors who think they're playing it conservatively by hewing to dividend-hikers need to look beyond the announcements. Companies do scale back on dividends when they hit rough patches. Moreover, the payouts are thin soup if stock prices slide. "Total return," urges Frank Felicelli, portfolio manager of the Franklin Equity Income Fund. "We want both current income, and we want to buy stocks at bargain prices."

So, amid the dividend-hiking frenzy, here are guidelines on what to avoid:


When the annual dividend as a percentage of the stock price climbs too high, investors should steer clear. A rising yield could mean the market is down on the stock and may not be confident the dividend is safe. How high is too high? Yields vary by sector, but a company yielding a percentage point or two higher than its best-performing peers is probably a bad bet. WAMU's yield, for instance, is a lofty 4.5%, while the far more diversified Citigroup yields 3.5%, even though Citi has more than doubled its dividend since the beginning of last year, to $1.60 annually. "Citi is much more broad-based," says Horizon's Carlson. WAMU declined to comment on "short-term fluctuations in our stock price."

Investors should be wary of stocks whose yields are much higher than their industries. As a group, the 374 stocks in the Standard & Poor's 500-stock index that pay dividends are yielding just 2.1%. Sectors whose yields are higher, such as financials (2.5%), are seen as riskier. Don't shun them, but tread carefully. Carlson suggests picking individual stocks that are on the lower-yielding ends of their groups. Real estate investment trusts, with yields of 6.7%, are an exception, since they typically pay out nearly all their income in dividends.


Companies whose yields fluctuate wildly over time are problematic. Erratic stock prices -- and often earnings -- leave investors unsure of what to expect. General Motors (GM) now yields about 4.5% with its $2 annual dividend, but historically its dividend has seesawed, plunging from an annual high of $3 to just 80 cents in as little as three years. Earnings, too, plunged from $8.58 a share in 2000 to $3.23 in 2001 before recouping to $7.14 last year. "We like to look back at history and see if there is a pattern over the last three or five or 10 years," says John Schmitz, managing director of strategic income for an asset management unit of Fifth Third Bank (FITB).


Companies that raise dividends at a faster rate than their earnings growth will soon run out of steam. Without an expanding pot of cash to draw on, the dividend eventually must be trimmed or eliminated, no matter how much boards and managers balk for fear of driving investors away. "Are they supporting the dividend out of current and expected earnings, or is it coming out of additional proceeds?" asks Standard & Poor's (MHP) market equity analyst Howard Silverblatt. A troubling case in point: Emerson, which raised its annual dividend 3 cents to $1.60 last year even though earnings from continuing operations fell 5.8%. A spokesman says the company is committed to long-term dividend growth and looking at one year is "misleading."


Companies facing legal woes sometimes pay generous dividends to keep investors happy. Altria Group (MO), parent of cigarette maker Philip Morris and Kraft Foods (KFT), pays $2.72 a share, for a yield of nearly 5% while R.J. Reynolds Tobacco pays an even better $3.80, yielding 6%. But tobacco is a plaintiff lawyer's punching bag, and some food companies face threats from obese litigants. "Yields climb when investors worry," says Jeremy Siegel, a Wharton School finance professor.

Ever since the tech boom distorted the market, dividend-paying stocks have renewed respectability. But there's ample reason to delve into the prospects for even supersafe "widows and orphans" stocks. A smart rule of thumb: Don't buy the yield, buy the stock. By Joseph Weber

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