Dividend paying stocks are all the rage these days. And why not? Stocks paying high dividends have performed very well recently. This is thanks in part to the 2003 Jobs and Growth Tax Relief Reconciliation Act, which cut the maximum federal tax rate on qualified dividends to 15% from as much as 38%. (Note: the tax cuts could sunset in 2010 if Congress does not vote to extend them.)
Dividend Funds Enjoy a Boom, Helped by Aging Baby Boomers
By Rob Wherry, The Wall Street Journal(*site requires registration)
But the notions that dividend paying stocks are a place of safety in down markets, or that dividend stocks are better for all time, are myths. We can't help but be reminded of the investing craftsman out there who believe their chosen category of stock is better forever. This is a foolish notion. Just as growth and value, country dominance, sector dominance, and big and small stocks exchange periods of outperformance through time, there is no credible reason to believe dividend stocks will outperform non-dividend paying stocks forever.
That said, it should be noted trends can last longer than many fathom, and we certainly aren't predicting a shift in performance based simply on mean reversion. There's nothing to say dividend paying stocks can't continue their grand performance for awhile longer.
We've got nothing against dividends, but it's important to see them for what they are…just one way companies share their profits with investors. Corporations can also enrich their investors by reinvesting cash into the company to grow profits, buying back shares, or making lucrative acquisitions. The idea that stock price appreciation is an inferior or less "real" form of investor compensation than dividends is poppycock.
In today's environment in particular, you have to wonder about companies that are accelerating their dividend payments. Corporate profits are surging as is global GDP, and there are record levels of cash on balance sheets. Most firms are better served using that cash to buyback shares or purchase other companies with high earnings yields, which can automatically increase earnings. At the very least, companies should be moving aggressively to take advantage of the huge growth potential out there. Even stalwart, defensive Consumer Staples companies have big opportunities in front of them as Emerging Markets continue to open and develop. As an investor, would you really want management paying you cash when they could be using it to grow earnings even more?
Those that need steady income from their portfolios can get it in a variety of ways. But folks tend to get anchored to bond coupon payments and dividends. Why not just make your own dividends by selling stock? Capital gains taxes are very low today, too.
In the end, paying dividends can be a good strategy, but they need to be appropriate for the specific financial position of the company in question. Thinking dividend paying companies are superior as a group is a misunderstanding of the principle.