Generating Income From Stocks

Investors relying on income from money market investments or U.S. Treasuries have struggled to receive interest income that has kept up with inflation. This phenomenon has been going on for several years. Last week’s Fed meeting discussed leaving rates at near zero percent thru 2013, virtually guaranteeing low rates on bonds and certificates of deposits. With this low interest rate environment, now is the time for fixed income investors to consider shifting some money from these low yielding investments to dividend paying stocks.

Let’s take a look at what dividends are and why investors would want them. When a company generates extra cash flow, they can do five things with it:

1) Pay back debt
2) Invest in the business
3) Buy another business
4) Repurchase shares
5) Return capital to the shareholders through dividends.

Many companies will do a combination of any of those options. The payment of a dividend is a signal of a company’s financial strength and confidence in its future growth prospects. History has shown us that companies that continually raise their dividend not only outperform the broader index, but do so with less volatility.

I would also point out that an extremely high dividend yield can be the sign of a company struggling financially. Additionally, in this article I am specifically discussing qualified dividends here, not dividends from Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITS,) which can have unwanted tax consequences for some investors.

Determining a good dividend involves analyzing the company’s financial statements. I look for companies that are still growing by reinvesting in their businesses. As a rule of thumb, I like companies that pay out half of their cash flows to shareholders, while paying down debt and reinvesting with the other half. Like all rules, there are exceptions. Utilities, for example, usually pay out a considerably larger portion of their cash flows, while reinvesting less, but are still suitable for an income portfolio.

Dividend paying stocks provide a steady flow of income, favorable tax treatments (0% or 15% versus taxation at a taxpayer’s current income), a potential hedge against inflation, and a source of portfolio diversification. The following table compares the potential yields of various types of investments.

November 11, 2011 After-Tax Yields on various investments:

While even conservative, dividend paying stocks are not immune to the volatility of the stock market, the income paid to investors outweighs the increased volatility over bonds. If investors add in the capital appreciation potential to the stream of income that stocks generate, then investing in dividend paying stocks looks much more attractive. For the last 90 years, dividends have represented over 50% of the total market return on stocks. Unfortunately beginning in the 1980s, dividend paying stocks fell out of favor as inflation and interest rates began to fall and the US fiscal situation improved. During the 1990s stocks appreciated at annual rates near 20% and dividend yields appeared small in contrast.

Today, however, that situation has changed and dividends are again being valued by investors. As stated, we are in a period of low interest rates that makes locking up investment dollars for any extended period of time unattractive. This means that if you bought a Treasury bond, the cost of a product worth the same value went up more over the past year than the amount of interest earned by the Treasury investor. This problem of income not keeping up with the rate of inflation can be offset by owning the stock of certain S&P 500 companies, which have a long history of increasing dividend payments. If a company increases its dividend by 7% a year, the dividend will double in 10 years. This will not only keep up with inflation but should outpace inflation if inflation remains below 7% (the long term average of inflation has been 2.5% a year.)

Stock prices are attractive right now as they have been beaten down in price by the financial crisis, the ensuing recession, and political uncertainty both within the US and externally. Stocks have yet to recover to their pre-crisis high in December 2007. The slow economic recovery has made investors shy of stocks because of the fear of things turning for the worse, but if you dig deeper and really look at the individual businesses themselves, you can quickly see that the current economic situation has created some real values. There are many businesses (and their stocks) that are generating steady cash flows and S&P companies are currently sitting on over $1 trillion of cash. Looking at those cash levels and the low payout ratio of the stocks in the S&P 500 (which are at a historically low ratio 0f 40%), the likelihood of dividend increases is strong. Purchasing a stock in a company with strong underlying growth and profit potential offers the additional possibility for the dividend to increase as well as potential for capital appreciation of the stock.

As you can see, there are many reasons to move from low yielding investments to dividend paying stocks. Among the benefits are a rising stream of cash flows from your investment, tax benefits of qualified dividends, and the potential for capital appreciation of your investment which is a hedge against inflation. If you have questions about how this article could fit your particular financial situation, please contact our office.

Paul Hassebroek
Director of Investment Strategy