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September 25, 2003 9:15 a.m. Attain Dividend Consciousness It’s time to move more of your assets into stocks with decent yields.

arlier this year, Microsoft Corp. (MSFT), which is roughly tied with General Electric (GE) as the most valuable company measured by market cap in the world, declared the first dividend in its 28-year history. On Sept. 12, it doubled that dividend from 8 cents a year to 16 cents — and I wouldn't be surprised if the figure went a good deal higher.

Microsoft isn't alone. The dividend tax cut spurred, among other increases, hikes of 75 percent by Citigroup (C); 50 percent by Biomet (BMET), the medical-device maker, and Wells Fargo (WFC), the country's fourth-largest bank; 27 percent by both broker Charles Schwab (SCH) and long-distance provider AT&T (T); and a whopping 167 percent by Kinder Morgan Inc. (KMI), an energy pipeline company. Most dramatically, Waste Management Inc. (WMI) announced last month that it will raise its annual payout from 1 cent a year to 75 cents.

Executives of companies as diverse as Hershey Foods (HSY), Exelon (EXC), Reebok International (RBK), Anheuser-Busch (BUD), and Qualcomm (QCOM) cited the tax change in their decisions to hike dividends. Overall, according to a study by the American Shareholders Association, a group that promotes the public-policy interests of shareholders, such as lower taxes, 52 percent more members of the Standard & Poor's 500-stock index have raised or initiated dividends so far in 2003 than did in 2002.

So, at first it might appear that the dividend tax cut, from a top rate of 38.6 percent last year to 15 percent, has helped push the stock market higher — by encouraging companies to start or increase their payouts, by allowing investors to pocket more of the proceeds and by increasing the transparency of a company's profits, thus lowering the investor's risk. When Harrah's Entertainment (HET), the casino company, announced its first-ever quarterly payout (of 30 cents) recently, its stock immediately shot up 9 percent.

Still, what's remarkable about the response to the dividend tax cut is not how much dividend-paying stocks have risen but how little.

After all, most of the high-tech companies that dominate the Nasdaq Composite Index continue to pay little or nothing in dividends — a yield of three-tenths of a percentage point for Intel (INTC), for example, and zero for such highfliers as eBay (EBAY), whose share price has nearly doubled in the last year, and Yahoo (YHOO), which has more than tripled. The Nasdaq itself is up about 40 percent this year, including dividends, compared with just 15 percent for the Dow Jones Industrial Average, whose 30 stocks yield far more.

There's no way to know for sure, but it's far more reasonable to conclude that the main impetus for rising stock prices has been the improving economy, with the cut in the capital-gains rate, from 20 percent to 15 percent, a close second.

My guess is that the dividend-cut will have a profound effect on the way companies deploy their capital and disperse their profits — and on the way investors allocate their money. But that change won't come overnight. The slow adaptation to the new realities of dividends — like the slow warming of investors to that wonderful innovation of 1997, the inflation-indexed Treasury bond — provides a golden opportunity. If you haven't already begun, you should start moving more of your assets into stocks that pay decent dividends. There's no need to panic, but there's a strong need to adopt a sort of "dividend consciousness" whenever you think about buying stocks.

Here are three recommendations for a sound dividend strategy:

• Growth counts most. Even stocks that have low yields today can produce high yields in the future if dividends grow at a fast pace. Edward Jones, the St. Louis-based investment firm, recently listed 15 examples of stocks from its model portfolio, whose dividends have grown impressively over the past 10 years.

For example, a decade ago, Bank of America (BAC) stock traded at $24.50 a share and paid a dividend of 93 cents for a yield of 3.8 percent. On Wednesday, the stock closed at $77.97 and paid a dividend of $3.20. The yield based on the bank's current price is 4.1 percent, but the yield based on the price 10 years ago is 13.1 percent. In other words, if you had bought Bank of America stock in 1993, you would be earning 13.1 percent on your original investment this year (not including the price appreciation) — and that yield should rise consistently in the years ahead.

Similarly, Edward Jones notes, Johnson & Johnson (JNJ) is today yielding 10 percent on a stock investment made 10 years ago; Citigroup, 20.9 percent; Wells Fargo, 13.2 percent; Pfizer (PFE), 9.8 percent; Clorox (CLX), 8.1 percent.

• Don't buy a stock just because it has a high yield. A stock's yield is its annual dividend payout divided by its price. If the price falls sharply then — owing to the laws of arithmetic — the yield will rise sharply. But sometimes prices fall for good reason, and the decline may indicate poor profit prospects and the likelihood of a cut in dividends in the near future, or even a suspension of payouts altogether.

Remember that companies don't promise to maintain their dividends year after year (as bond issuers do with interest payments). It's true that firms are extremely reluctant to reduce their dividends and, for that reason, keep their payouts reasonable. A dividend, then, is a more reliable indicator of a firm's health than the net accrual earnings it reports with great fanfare every quarter. But dividends can disappear, and a falling share price often foreshadows such an undesirable event.

For that reason, it's unwise to buy a stock with an astronomical yield. The stock almost certainly carries high risk along with such a high potential reward. I recently looked at the 75 highest-yielding stocks among the thousands followed by the Value Line Investment Survey. I eliminated real estate investment trusts (which have to pass nearly all their profit on to shareholders and really can't be compared with conventional stocks) and the few exchange-traded bond funds that trade as if they were equities. That left 43 stocks. Of those, only 10 had a Value Line rating of at least "3" (average) for both timeliness and safety. In other words, slim pickings.

By the way, the list was dominated by tobacco and utilities, including Altria Group (MO), with a current yield of 6.7 percent, and TECO Energy (TE), 5.7 percent. The most interesting entries were Lance (LNCE), the snack-food company, with a yield of 6.3 percent; Bassett Furniture (BSET), 5.4 percent; and the Spain Fund (SNF), an exchange-traded fund that owns shares in such Spanish companies as Telefonica S.A. (TEF) and Banco Santander Central Hispano (STD) and yields 7.1 percent.

In a fascinating report on "dividend myths," Alan F. Skarinka, chief market strategist at Edward Jones, notes that a high yield can indicate not only an imminent dividend cut but also a "company's inability to grow." In a 10-year study, he found that the sectors with the highest average dividend yields — such as utilities and telecommunications — also had the lowest average total annual returns between 1993 and 2002, including both dividends and price appreciation. Conversely, the low yielders (technology and health care) produced the highest total returns. The only anomaly was the financial sector, with a dividend yield of 2.3 percent and a total average annual return of a decent 10.4 percent.

Still, there are many fine companies with decent yields — not too high, not too low. A good place to look is Value Line's Portfolio II, comprising "stocks for income and potential price appreciation." Among the selections: General Mills (GIS), consumer foods, with a yield of 2.3 percent; BB&T Corp. (BBT), regional bank, 3.5 percent; Merck & Co. (MRK), pharmaceuticals, 2.8 percent; Verizon Communications (VZ), telecom, 4.3 percent; and Southern Co. (SO), electric utility, 4.7 percent. By comparison, last week, the Dow stocks were yielding an average of 2.2 percent; the S&P 500 stocks, 1.7 percent, and the five-year U.S. Treasury bond, 3.0 percent.

• Most dividend funds disappoint, but there are other choices. Sad, but true. In a review of mutual funds that purport to focus on dividend-paying stocks, I found few good choices. I was put off by high up-front fees and low returns compared with the benchmark S&P 500 Index. Dividend funds that beat the S&P tended to have paltry yields.

The best I could find overall was T. Rowe Price Dividend Growth (PRDGX), which yields 2 percent and returned almost precisely as much as the S&P over the past 5- and 10-year periods; the expense ratio is just 0.83 percent, and the main attraction is that risk levels are below those of the market as a whole.

Any dividend fund that has more volatility than the market isn't worth owning. Indeed, lower risk is one of the main reasons for buying stocks with decent yields. In 2002, for example, when the S&P fell 22 percent overall, stocks in the index that paid a dividend fell only 11 percent, while non-dividend-paying stocks fell 30 percent. Still, dividend stocks don't rise as much in good times. The Price fund, run by manager Thomas. J. Huber, has returned 15 percent so far this year, three full percentage points behind the S&P.

The top-five top holdings of Price Dividend Growth at last report were Pfizer, which currently yields 1.9 percent; Citigroup, 3.1 percent; ExxonMobil (XOM), 2.7 percent; Wyeth (WYE), pharmaceuticals, 1.9 percent; and First Data (FDC), information processing for financial firms, at just 0.2 percent.

But a more attractive option for most investors may be simply to add stocks that pay dividends of, say, 2 percent or more to your portfolio. That's what I have been doing lately. It's my expectation that as it starts to dawn on investors that the new tax law is boosting their after-tax equity income by a third, they will get on the bandwagon, driving up the prices of dividend stocks (and, by the way, driving down their yields). So the time to act is now. Even if dividend stocks don't outperform the market as a whole, they have proved their value over history, providing a smoother ride to port, even in hurricane seas.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned above, Glassman owns Microsoft and ExxonMobil. This article originally appeared in the Washington Post.