Local Radar

Most investors understand that there are two components to a stock’s total return: capital appreciation, or an increase in stock price, and income from dividends. Unfortunately, investors frequently focus on capital appreciation and ignore dividends, particularly during bull markets when stock prices are increasing at above-average rates. Yet market history teaches us that dividends have been an important component of return for stocks. And looking ahead, we believe the case for dividends continues to build.

Market history helps underscore the often-overlooked importance of dividends.  According to analyses done by Citigroup Investment Research, over the past 100 years, dividends have accounted for 48% of the S&P 500’s total return, versus 52% for price appreciation. That ratio has held up recently, as well. For the past three years, dividends provided 49% of the S&P 500’s return, even though many investors view dividends as relics from the past.

Why Dividends Matter

Dividend-paying stocks can play an important role in a well-diversified portfolio by helping cushion the impact of falling equity prices and rising interest rates. For example, if a stock’s price drops 5% but pays a 3% dividend yield over the same period, an investor’s total return would be -2%. No investor wants losses, of course, but the dividend helps reduce the impact of the price drop.

Similarly, when interest rates rise, bonds that pay fixed interest rates decline in value. But companies can increase their dividends, even in a period of rising rates, and that may make these stocks relatively more attractive to investors.

We believe three key issues explain why the case for dividends has become more compelling lately:

Ø      The 2003 Tax Act reduced the tax rate on qualified corporate dividends.

Ø      Relative to history, corporations today have more financial flexibility to increase their dividends.

Ø      Retiring baby boomers may look to dividends to supplement or replace their retirement income, driving demand for, and the prices of, dividend-paying stocks.

Reduced Tax Rate

Although we continue to believe that Congress will not allow this provision to expire in 2008, given its popularity among voters, higher-than-expected deficits associated with the costs of the Iraq War and Hurricane Katrina have increased the risk that this could occur.

The 2003 Job Growth and Taxpayer Relief Act reduced the tax rate on qualified corporate dividends to 15%. (The 15% rate applies to taxpayers whose top bracket exceeds 15%; taxpayers in the 5% or 10% brackets pay a 5% tax on qualified dividends.) Before that reduction, dividends were taxed as ordinary income, which incurs a maximum rate of 35% in 2005. The result of the rate reduction: Dividends’ after-tax returns have increased significantly. For example, if you are in the 35% tax bracket and earn $5,000 interest income, your federal tax liability is $1,750 versus just $750 for qualified dividends.

Bear in mind, however, that the IRS imposes three requirements before you can claim the lower rate:

    * A U.S. corporation or a qualified foreign corporation must have paid the dividends.
    * The dividends are qualified. Dividends from preferred stock,  real estate investment trusts (REITs), and certain other investments generally do not qualify.
    * You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Improving Corporate Cash Flow

In the two years since the tax rate was lowered, the number of companies initiating dividends has increased from six in 2002 to an average of 46 for 2003 and 2004, according to Citigroup Investment Research.  The percentage of firms raising dividends has increased, too. As of March 2005, 15% of companies have raised them versus roughly 8% in March 2002.

The outlook for additional increases is promising, in our opinion. Firms are enjoying lower interest expense, strong free-cash flow, and improved balance sheets. Additionally, dividend payout ratios among the S&P 500 remain low relative to historical levels. Since 1940, the average dividend payout from operating earnings has been 48%. The current ratio is just 29%.

Baby Boomers’ Influence

In 2005, the first baby boomers turn 59 years old, with most now firmly into the important 45–64 age bracket. As these individuals born between 1946 and 1964 approach retirement, they may demand income-producing investments. According to the Department of Health and Human Services’ Administration on Aging, there were 35.9 million people 65 and older in 2003, the latest year for which data are available. These individuals represented 12.3% of the U.S. population, or about one in every eight Americans. By 2030, it is estimated there will be about 71.5 million older people, or about 20% of the population.

Boomers, however, may have unique demands. As they retire, they may not accept drastic cutbacks in their lifestyles, and that means they will have to replace their earned income with unearned income. Because boomers can expect to live 20 years or longer after retiring, they will need sources of funds that keep pace with inflation. As a result, they may be attracted to stocks with histories of rising dividends.

All of this may be good news for investors. Whether you seek to balance growth with income or you require an investment strategy with an income orientation, history and demographics suggest that dividend-paying stocks can potentially play an important role in your investment portfolio. 


Will Davis is a Financial Consultant with Smith Barney located in Augusta, Ga. and may be reached at 706-724-2601 or 1-800-241-2401.

Smith Barney does not provide tax or legal advice. Please consult your tax and/or legal advisor for such guidance. Smith Barney is a division and service mark of Citigroup Global Markets Inc. Member SIPC.