As investors look for anything that might enhance their portfolio’s overall return, the subject of whether dividends are worth the effort have moved to the forefront. Many current retirees and those poised to retire understand the nature of what this provides but there are subtle differences in what they actually are, the story they tell about the company that is issuing them and whether or not they are as they seem.
First let’s clarify what a dividend is. When an established company continues to grow, they may decide at some point to reward their shareholders with a share of the profits. (Most newer or smaller capitalized companies tend to plough any profits back into their businesses, rewarding their investors with enhanced share value rather than direct payments from profits.) The dividend the business issues can be a one time offering or a steady issue. If the dividend is the right size – not too sizable as to require constant revisions over the years but just enough to allow for continuous increases – it can be used a measure of the company’s potential to continue to grow and be profitable.
Investors look for steady when it comes to dividends, reassuring them that not only wil the company be profitable but the cash flow is expected to remain intact no matter what the market does. In a downturn although, dividends may be cut to keep the company more liquid in times of turmoil. Investors often turn away from these types of stocks in favor of more risk (which they see as increased return) and greater potential. But dividends that are adjusted are often done to keep the yield in line, a measure of profits (the dividend) as divided by the stock price. Too high a dividend against the share price means the company may be shedding more profits that is sustainable. So they adjust the payout to prepare for leaner times.
Dividends, taxes and inflation. Not only will a company with a much higher quality rating than its riskier small and mid cap brethren issue a dividend, that may be, at least for the long-term investor, a better-than-conservative investment. Fixed income investments such as bonds are taxed at your current income rate and because inflation have a negative effect on those dollars. Dividends on the other hand, are taxed at the current 15% rate and if the company is doing what it is supposed to do, will increase those dividends steadily over time, offsetting inflation.
While there are many people who invest for dividends via individual stock ownership, the vast majority of us will seek out the safety-in-numbers approach offered by mutual funds. And this is where it gets confusing.
Looking only at the name of the fund can be misleading. Equity-income funds for instance offer the investor the opportunity to chase high yields. On the surface, you might think that this is good idea. But the potential that those yield will hamper growth (because they are paying too much relative to the stock price) or cause those dividends to be reduced (as profits diminish) are higher in these types of funds that those looking for dividend growth.
Dividend growth funds, sometimes referred to a dividend builders often pay a slightly higher price for the stock in the portfolio in the hope that the dividend will increase over time. Lower yields do not signify any problem with the investment strategy but do indicate that to benefit for an absolute return (a fund focused primarily on yield), you need to stick with the fund for a longer period of time. Both have their own set of risks that require the investor to dig into the prospectus – but hey, you do that anyway, right?
Jason Brady, who helps manage Thornburg Investment Income Builder understands the problems facing the markets. With banks cutting dividends, once the easiest source for these fund managers to find dividends for their funds, Mr. Brady suggests that “Fewer companies are growing their dividends now because fewer companies are growing,”
The returns on these funds can range widely from 2% to 20% for the dividend growth/builder funds to an average of about 16% for the absolute return or equity-income funds. But the risk, and there is some, is offset by the dividend and may even act as insurance in future market mishaps.
As banks retreat from dividends, and probably more so under the new financial regulatory bill waiting to be signed into law by President Obama, other companies are taking up the slack. Numerous business are hoarding cash (about $1.8 trillion is estimated to be sitting on the sidelines in businesses alone) and many are issuing dividends and increases as shareholders question the logic.
In your retirement plan, such as a 401(k), dividend focused mutual funds can play a more important role than any other conservative investment (such as bond funds or target date funds) in part because they not only offer equity exposure (in high quality companies) but a reward for having done so that is unlikely to slow or be threatened by credit woes.
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