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The change involves dividends. Suddenly, many of the very best companies are providing dividend yields greater than at any time since the mid-1990s — greater, in fact, than the interest rates on short-term Treasury securities.
A big story in recent years has been the dwindling dividend yield — that is, the percentage of a company's stock price represented by its dividend. At the end of 1999, the yield on the average stock in the Dow Jones industrial average hit an all-time low of 1.47%, after a steady decline that began a quarter-century ago, when yields were around 5%. But the latest figures show that the Dow on Aug. 16 was yielding 2.12% — that's a gain of 44% since 1999. Even a year ago, the Dow was yielding just 1.75%. The average yield for the stocks of the broader Standard & Poor's 500-stock index last week was 1.69%, an increase of one-fourth over last year. I calculated the yield on the 30 individual Dow stocks last week by dividing the price of each into the dividends it paid over the past 12 months. Fifteen were yielding more than 2%, and seven of those were yielding more than 3%. In normal times, 2% or 3% sounds pretty paltry, but not today, with interest rates the lowest in a generation. Compare, for example, the 2.1% yield on the Dow with the 2.1% yield on two-year U.S. Treasury notes and the 3.3% yield on federal securities that mature in five years. Meanwhile, Dow component DuPont Co. (DD), the giant chemical company, is yielding 3.3%, and Caterpillar Inc. (CAT), the world's largest construction-equipment maker and also part of the Dow, is yielding 3.0%. In other words, if you invest $10,000 in Caterpillar today, you will receive (if the payout stays the same) $1,650 in dividends over the next five years. If you invest in five-year Treasury securities, you will receive the same $1,650. With Treasurys, of course, you are guaranteed to get your original $10,000 back at maturity. But with Caterpillar, you are likely — though certainly not guaranteed — to get back more. The typical stock has historically appreciated at about 8% a year (over the past 10 years, for instance, Caterpillar stock has quadrupled, growing at about 14% annually). If Caterpillar rises at just 5% annually, your $10,000 worth of stock will grow to $12,763. In addition, Caterpillar's dividend should rise. Figure a modest 4% annually. Final tally of income and capital gains: Treasury note, $1,650; Caterpillar, $4,413. To put it simply: If you invest today in a portfolio of Dow stocks, you will be getting the same annual income as with two-year Treasury notes — plus the prospect of both capital gains and rising dividends. This near-parity between stock and short-term bond yields is a very attractive situation — and a highly unusual one over the past several decades. In 1986, for example, when the Dow was yielding 3.5%, two-year Treasurys were yielding 6.9%. In 1995, the Dow yielded 2.3%, Treasurys 6.2%. Using data from the Federal Reserve going back to 1976, I could not find a single year in which two-year T-notes were not yielding more (in most cases, substantially more) than the Dow. Currently, rates are within a tenth of a percentage point of each other. The next-best year was 1993, when T-notes yielded an average of 4.1% and the Dow yielded 3.1%. But even juicier than the high yields for the Dow as a whole are the slightly lower yields provided by most consistent Dow performers. Consider Procter & Gamble Co. (PG), which has increased its dividend annually for more than 40 years. In 1998 and 1999, P&G's annual dividend yield was 1.3%; it is currently 1.8%, the highest since 1996. Coca-Cola Co. (KO), another Dow company that has been boosting its dividend each year for decades, now yields 1.5%, compared with just 0.9% in 1997. The environment for solid dividend-paying stocks has improved for three reasons: First, stock prices have dropped, and, since yield is dividend divided by price, a sharply falling price means a sharply rising yield. At one point in 1998, for instance, Coke traded at $88 a share and paid a per-share dividend of $0.60; that's a yield of only 0.7%. Coke recently closed at $52.70 and paid a dividend of $0.80 over the past 12 months, for a yield of 1.5%. Second, dividend payouts keep increasing. Companies are extremely reluctant to lower their dividends, even if profits fall. At Coca-Cola, for instance, profits dropped from $4.2 billion to $3.5 billion in 1998, but Coke increased its dividend anyway, from $0.56 to $0.60 per share. Coke, like most companies, had plenty of cushion since it distributes only one-third to one-half of its annual earnings to its shareholders. In 1997, the payout ratio (dividends divided by earnings) was 34%; in 1998, it rose to 42%, still providing a margin of safety. (By the way, the average payout ratio for all stocks this year is expected to be 30%, compared with 51% for all years since World War II.) Third, interest rates in general have plummeted as the economy has slowed and inflation, over the long term, has been reduced, both because of better stewardship by the Fed and a rising supply of goods produced at home and abroad. Five-year Treasury rates went from 11.5% in 1980 to 8.4% in 1990, 6.2% in 2000, and just 3.3% recently. Even before their relative rise in yields, dividend-paying stocks were excellent investments, mainly because of their rising payouts. For example, despite its legal problems as a tobacco manufacturer, Philip Morris Cos. (MO), the diversified consumer-goods firm, has increased its annual dividend at an average of 11% annually since 1992. A share of Merck & Co. (MRK), the giant pharmaceutical house, paid a dividend of just $0.09 a share in 1986. This year, a share will pay $1.42. An investment of $1,000 in Merck stock 16 years ago generated $20 in dividends. This year alone, that original investment will generate $258. T. Rowe Price, the Baltimore-based investment firm, recently looked at 18 dividend-paying large-cap stocks that consistently produced above-average growth in dividends and earnings over the past 15 years. Many of them are now paying dividends that represent annual gains of 15% and more of their original cost, including Citigroup (C), at 30%; Pfizer Inc. (PFE), 15%; Home Depot Inc. (HD), 28%; Philip Morris, 32%; and General Electric Co. (GE), 16%. GE is a good example. When its stock dropped to $24 a share last month, it was yielding 3% — higher than in any year since 1994 (between 1998 and 2001, GE's average yield was less than 1.5%). GE's stock price has rallied in the past month, but its yield is still high — at 2.2% — in comparison with recent years, a sign that the stock is a relative bargain. Dividends were neglected — and even derided — by investors during the 1990s. After all, with flashy non-dividend-paying companies such as Oracle Corp. (ORCL) and JDS Uniphase Corp. (JDSU) soaring in price, who needed quarterly checks in dribs and drabs? In addition, the tax bite is brutal. Since dividends are taxed at both the corporate and personal level, the government's take can be as much as 60% on the profits used for the payout. So it's not surprising that the proportion of companies that pay no dividend at all has hit an all-time high (about one-fourth of all stocks). But a bear market, along with falling interest rates, is making dividend payers very enticing, both for their yields and for their record of stability and value. Dow Theory Forecasts newsletter points out that "since the tech sector began imploding in 2000, dividend-payers have beaten the rest of the market by 44 percentage points." During the first half of 2002, S&P stocks that did not pay dividends declined 32% while S&P dividend payers fell only 9%. Finally, a dividend is the best evidence of a company's financial health. At a time when investors are skeptical of the revenue and earnings that corporations are reporting, dividends can give them confidence. Dividends are cash; you can't fake them for very long. At President Bush's economic summit in Waco, Texas, earlier this month, the economists in the crowd were talking about a proposal, gaining favor at the White House since the accounting scandals, to tax dividends only once. In the meantime, try to keep your dividend-paying investments in the tax-deferred part of your portfolio — an IRA or 401(k) plan, for instance. Also, unless you need the income, use the cash from dividends to purchase more shares, a process that will boost your stock holdings dramatically over time through the power of compounding. The June issue of the AAII Journal, published by the American Association of Individual Investors, carries an extensive directory of companies with dividend reinvestment plans (DRIPs), which make the process easy and inexpensive. As for dividend-paying stocks: I am partial to the Dow itself, all but one of whose components (Microsoft Corp.) pays dividends. You can buy the 30 companies in the average all at once through an exchange-traded fund called Diamonds Trust (DIA), which trades on the American Stock Exchange as if it were an individual stock. It's priced at 1/100th of the value of the average, or $90 when the Dow is 9000. And don't be lured to stocks merely because their yields are high. A towering yield is often a sign that a company is about to lower, or even omit, its dividend entirely because of bad business. (The yield is high, in fact, because the stock price has dropped in anticipation of the news.) My preference is for companies that are yielding in the range of 1.5% to 3.5%. Remember especially that "cash dividends . . . force discipline on companies, especially in allocating capital resources. If the past few years suggest anything, it is that corporate America needs more discipline," writes Edwin D. Everett of David L. Babson & Co., a value-oriented Cambridge, Mass., investment firm. "Dividends are an informal contract — specific amounts to be paid at specified times — that firms are most reluctant to break," Everett continues. "Payment hikes come more slowly as a result, but when one comes, investors can be sure management has thought the decision through, and is serving only the shareholder's interest in returning cold hard cash." At a time like this, that's very, very reassuring. — James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned in this article, he owns General Electric and Microsoft.
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of the most important changes in the investment environment occur when
hardly anyone is looking. One of those changes is happening right now
— while the financial world is distracted by the sickening decline
in stock prices, the shaky economy, and threats of terrorism and war.
