The case for high-yield stocks
By Laura Bruce • Bankrate.com

Would elimination of the dividend tax or a hefty reduction in its rate spur you to invest in high-yield stocks?

President Bush is proposing that the tax on dividends be eliminated. While there is considerable opposition to the proposal, it's widely believed that at least a 50-percent tax cut will pass.

Politics aside, perhaps you should consider allocating a portion of your portfolio to high-yield equities or mutual funds regardless of the outcome in Washington, D.C.

When a fixed-income vehicle, such as a one-year certificate of deposit, is paying 1.48 percent, is it worth taking on some risk to invest in the motor vehicle industry with General Motors stock yielding 5.40 percent or Ford at 4.13 percent?

Other examples of high yielders are Philip Morris at 6.23 percent and Shurgard Storage at 6.68 percent.

Dividend-paying stocks tend to fare better, losing less value, during bear markets. According to data provided by Standard & Poor's, dividend-paying stocks in the S&P 500 were down an average of 11.13 percent in 2002, while stocks that don't pay dividends were down an average 30.34 percent.

The biggest negative is that dividends are taxed as ordinary income. Instead of paying the much lower capital gains tax as you would when a stock price appreciates, you'll pay the same tax rate as applies to your paycheck.

That, presumably, will change at least to some extent when Congress finishes wrangling with the President's proposal.

Stewart Welch, certified financial planner and founder of The Welch Group in Birmingham, Ala., says cutting or eliminating the tax on dividends should bring about a sea change in investing.

"What the tax package should do is create some opportunities to reconstruct a portfolio. The biggest mistake people make is keeping whatever they're doing in place and assuming the change doesn't affect them, so they don't make changes in their portfolio. This will change the nature of the future of investments."

Welch says he believes money will quickly gravitate toward dividend-paying companies, and growth companies, such as Microsoft with $40 billion in cash, will have to rethink their strategies because they'll be under significant pressure to pay dividends.

Stocks that pay hefty dividends have long been a favorite of older investors who are often looking for an income stream that leaves untouched the principal investment, allowing it to grow.

Dividend-paying stocks lost favor during the bull market mania of the '90s. Growth stocks of corporations that pumped profits back into the company instead of handing out dividends became the best way to get a fast, fat gain on investments.

Back in fashion
But now high-yield stocks are fashionable again as investors try to get some sort of return out of stocks that are bottoming.

The common thought is that companies that pay dividends tend to be a little more conservative than companies that reinvest everything. But that doesn't mean you should pump money into a high-yielding stock without doing plenty of homework. Even companies that have built a solid reputation can be risky.

"There are always some unknowns," says Scott Lee, also with The Welch Group.

"Ford always paid strong dividends in the past but they have this pension liability, which may be a ticking time bomb. You have to look at the whole company, the whole sector.

"People are chasing yield. To buy Duke Energy because it's paying 14 percent is asinine."

Kevin Hassett, a tax economist at the American Enterprise Institute in Washington, D.C., says yield can be misleading because it's trailing, meaning it reflects the past.

"You can make a really big mistake and buy a dog of a company if the price drops. Ford was $16 a share and now it's $9.94. The dividend is 40 cents per share. They have a big yield because the price has dropped a lot. There's a big question as to whether the dividend is sustainable. Does Ford have too much debt and will it cause problems? Those questions ultimately relate to share price and dividend. If you have a big yield because the price just dropped, it doesn't mean it's a good deal."

The dividend yield can be an indication of corporate stability; the company is on solid financial ground and has cash to distribute to shareholders. On the other hand, it can be an indication of risk if a company is going through a rough time. The share price is dropping but the company doesn't want shareholders dumping their stock so the company maintains the dividend while the stock price slumps, driving up the yield.

Using the Ford example, here's how a declining stock price causes the yield to increase.

Ford at $16 per share:

$0.40 ÷ $16 = 2.50 percent yield

Ford at $9.94 per share:

$0.40 ÷ $9.94 = 4.02 percent yield

Higher yield isn't always a better deal
The higher yield doesn't mean you're getting a better deal; you'll still receive 40 cents annually for every share you own no matter what the share price. But it may mean you're taking on more risk, since the share price may be dropping because of bad things happening at Ford.

Many investors will take the risk with a company such as Ford. After all, many growth stocks tank and those shareholders don't get a dime.

While long-standing, dividend-paying companies aren't immune from rough times, a company that has consistently paid dividends, and increased them over time, can be an excellent investment.

"The company must have positive cash flow, and it should have a major position in its industry," says Benjamin Tobias, CFP at Tobias Financial Advisors in Plantation, Fla. "All typical reasons why you buy a value-type stock. You're not buying with the idea that this is a company at risk.

"When you look at Microsoft, you're putting all your eggs in the capital appreciation basket vs. buying GE where we hope there's capital appreciation, but we're also looking to receive cash from the company while it's profitable."

Tobias says if you're looking at stable companies such as GE and you've considered how much risk is already built into your portfolio, it may be OK to reallocate some low-yielding fixed income to a group of high-yielding stocks.

"I would never say take a retiree's entire fixed income portfolio and put it in GE earning 2.99 percent vs. a money market, but if you were to take a group of 20 high-yielding dividend stocks and put a portion of a retiree's fixed income into those stocks it could be good."

Stewart Welch also favors a high yield portfolio of about 20 stocks.

"Follow the strategy of remaining diversified by the number of stocks and by industry. You want to have at least three separate industries and a minimum of 20 stocks.

"You and I might not have a concern about Ford going bankrupt, but it could happen. If Ford represents 5 percent of the portfolio it's not a very negative thing. It's something we can recover from and maybe another stock doubles to 10 percent."

Look out for taxes
Be aware that reduction or elimination of dividend taxation would affect only stocks or funds that are held in taxable accounts. If your equity holdings are in a tax-deferred retirement account, you'll pay income tax at withdrawal.

Nevertheless, investing a portion of your portfolio in dividend-paying stocks or funds can be very profitable even if you have to pay tax on the gains.

If you don't have a financial planner and you're not comfortable selecting individual dividend-paying stocks for your portfolio, consider a mutual fund that invests in dividend stocks. You'll get a professionally managed portfolio at relatively low cost. You'll still have to do some research to select the fund or funds that are best for you, but it narrows the field considerably.

-- Posted: Jan. 10, 2003