Dividend investing is too good to pass up

Dividend income, one of the few certainties in any market cycle, deserves a closer look and a more strategic approach by financial advisers as Congress decides how to deal with the expiring Bush administration tax cuts.

Corporate cost cutting over the past few years, combined with reduced spending, has left a lot of companies with huge piles of cash on the books. This usually bodes well for dividend investors.

However, if it looks as if Congress will raise the tax rate on dividends, that cash might be directed toward either one-time special-dividend payments before taxes go up or stock repurchase programs.

“I think the number of companies paying special dividends would increase if dividend taxes were significantly increased,” said Tom Graves, an equity analyst at Standard & Poor’s Financial Services LLC. The Bush administration tax cuts are scheduled to expire Jan. 1.

Tax rates can have a significant effect on corporate dividend policies. When taxes on dividends were reduced in 2004 to the current 15% rate, corporate America reacted.

“When the dividend tax rate dropped to 15% in 2004, we saw some major dividend policies introduced by such notable companies as Microsoft [Corp.], Intel [Corp.] and Waste Management [Inc.],” said Henry Sanders, manager of the $230 million Aston/River Road Dividend All Cap Fund (ARDEX).

Microsoft (MSFT) not only introduced its first dividend payment but also paid a one-time special dividend of $3 a share.

This is exactly the kind of thing that advisers need to be looking for toward year’s end if it appears that Congress is favoring a higher tax rate on dividends.

Whether lawmakers move to keep the dividend tax rate next year at 15%, raise the rate to ordinary income levels or find some other compromise, dividends still represent a significant portion of total return that shouldn’t be ignored by advisers for their clients.

“Over the past nine decades, dividend income has represented between 20% and 40% of the total return of the S&P 500, so you ignore them at your own peril,” said John Buckingham, chief investment officer at Al Frank Asset Management Inc., which has $450 million under management and another $1.1 billion under advisement.

While the political analysts and prognosticators carry on the tax debate, investors should align themselves with companies that have a proven history of dividend payments, said S&P mutual fund analyst Todd Rosenbluth.

“Look at the dividend history of each company,” he said. “That will show you if it’s a part of their corporate culture, and something that investors are expecting.”

To that end, it helps to think in terms of what a dividend represents on a corporate balance sheet.

“A dividend policy gives tremendous insight into what the corporate board is doing, because a dividend is the only tangible thing that is forward-looking,” said Mr. Sanders, who noted that it would be a mistake if investors started letting “the tax tail wag the dog.”

Josh Peters, an analyst at Morningstar Inc., agrees that investors need to focus on dividend-paying companies more than on the debate in Washington.

“I have no idea on how to do research on Congress,” he said. “[But] a [longtime dividend payer] company like Procter & Gamble is not going to change its dividend policy, no matter what happens to the dividend taxes.”

A major part of the appeal of dividend-investing strategy, particularly in times of extreme market uncertainty and volatility, is that it helps investors take advantage of market declines.

“In March 2009 when the stock market bottomed, a lot of people sold low, but reinvested dividends helped investors buy low,” said Donald Schreiber, chief executive of Wealth Builders Inc., which has nearly $500 million under management.

“Left to their own devices, investors will not buy when risk is high,” he added. “But dividend payments create automatic dollar cost averaging, and forces investors to buy low.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].