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The power of dividends in a portfolio

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By Doug Awad

It wasn’t so long ago that many investors regarded dividends as roughly the financial equivalent of a record turntable at a gathering of MP3 users – a throwback to an earlier era, irrelevant to the real action. But fast forward a few years and things look different.

Since 2003, when the top federal income tax rate on qualified dividends was reduced to 15 percent from a maximum of 38.6 percent, dividends have acquired renewed respect. Favorable tax treatment isn’t the only reason, either. The ability of dividends to provide income and potentially mitigate market volatility is also attractive to investors.

As baby boomers approach retirement and begin to focus on income-producing investments, the long-term demand for high quality, reliable dividends is likely to increase.

Why consider dividends: Dividend income has represented roughly one-third of the monthly total return on the Standard & Poor’s 500 since 1926. According to S&P, the portion of total return attributable to dividends has ranged from a high of 53 percent during the 1940s – to a low of 14 percent during the 1990s when investors focused on growth.

If dividends are reinvested their impact over time becomes even more dramatic. S&P calculates that $1 invested in the S&P 500 in Dec. 1929 would have grown to $57 over the following 75 years.

However, when coupled with reinvested dividends, that same $1 investment would have resulted in $1,353. (Bear in mind that past performance is no guarantee of future results, and taxes were not entered into the calculations.)

Dividends can be especially attractive if the market is producing relatively low or mediocre returns. In some cases dividends could help turn a negative return positive.

Dividends can also help mitigate the impact of a volatile market by helping to even out a portfolio’s return. Dividends are also a reliable indicator of a company’s financial health.

Investors have become more conscious in recent years of the value of dependable data as a basis for investment decisions, and dividend payments aren’t easily restated or massaged. Finally, many dividend-paying stocks represent large, established companies that may have significant resources to weather an economic downturn- which could be helpful if you’re relying on those dividends to help pay for living expenses.

The corporate incentive: Financial and utility companies have been traditional mainstays for investors interested in dividends but other sectors of the market also have begun to offer them. For example, investors have been stepping up pressure on cash-rich technology companies to distribute at least some of their profits as dividends rather than reinvesting all that money to fuel growth.

Some investors believe that pressure to maintain or increase dividends imposes a certain fiscal disciplined on companies that otherwise might be tempted to make ill-considered acquisitions. However, according to S&P, corporations are beginning to favor stock buybacks rather than dividend increases as a way to reward shareholders. If it continues, this trend could make ever-increasing dividends more elusive.

Differences among dividends: Dividends paid on common stock are by no means guaranteed. A company’s board of directors can decide to reduce or eliminate them.

However, a steady and increasing dividend is generally regarded as one sign of a company’s ongoing health and stability. For that reason most corporate boards are reluctant to send negative signals by cutting dividends.

That isn’t an issue for holders of preferred stock, which offer a fixed rate of return paid out as dividends. The tradeoff is that preferred shareholders do not participate in any company growth as fully as commons shareholders do. If the company does well, the preferred shareholders still receive the same dividend. However, this class is “preferred” because dividends are paid before any common dividend can be paid.

While preferred shareholders do not have voting rights, their claims on company assets are satisfied before those of common stockholders in case the company faces financial difficulty. Preferred shares tend to act like bonds and can be affected by changing interest rates.

Taxes and dividends: Some dividends, such as those paid by real estate investment trusts (REITS) and master limited partnerships, don’t qualify for the 15 percent maximum tax rate and may be taxed as ordinary income. Also, the 15 percent maximum rate is scheduled to expire in 2010 (maybe sooner depending on who is elected in November) and there was no guarantee dividends will continue to receive favorable treatment.

Be aware that some so-called dividends from U.S. saving and loans, federal savings and loan associations may be considered interest.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information was partially developed by Forefield, Inc. an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security.

Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates, Inc. Inc does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional.