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Why Dividends Stocks Rock

Posted By Jim On 12/10/2009 @ 12:06 pm In Investing | 26 Comments

If you can keep your wits about you while all others are losing theirs, and blaming you. . . . The world will be yours and everything in it, what’s more, you’ll be a man, my son.

That’s a famous line from Rudyard Kipling’s If [3] and if you followed that advice the last year (the first part anyway), especially in the stock market, you would’ve done very well and kept a few gray hairs at bay. Since the S&P hit its low in March of 676.53, it’s come roaring back a stunning 63.4% since then. While it’s still down from where it was before the recession (it was 1251 on Sept 19, 2008, down 11.64%), you have to admit it’s a pretty amazing recovery in such a short period of time.

We benefited from being young, with decades until retirement, and one thing we’ve been looking into is dividend yielding stocks in our regular non-retirement brokerage accounts.

Favorable Tax Benefits

Dividends are taxed at the investor’s long term capital gains tax rate, which is 0% for taxpayers in the 10% and 15% tax brackets and 15% for everyone in the 25%, 28%, 33%, and 35% tax brackets (see 2009 tax brackets [4]).

It’s a common strategy for those on fixed income to invest in dividend yielding investments for this very reason. Interest from your savings account is taxed as ordinary income, making the tax equivalent yield [5] (tax equivalent yield calculator [6]) of a dividend bearing stock at the same percentage much higher.

This makes them well suited for non-retirement accounts, where taxes are a constant factor in decision making. In a Roth IRA, it wouldn’t matter because nothing is taxed. In a Traditional IRA, everything is eventually taxed at your marginal tax rate. Being in this middle ground gives you no benefit.

Why Dividends Suck

The biggest argument against dividends is that a company should retain those earnings to grow the business and subsequently it’s share price. If a company is writing checks to its shareholders, paying for it with earnings, then those dollars can’t be used for capital investments, new hires, new projects, etc. It’s not difficult to see the logic in that argument.

To this I have two counter arguments:

  • Most companies that offer dividends aren’t in super-charged growth mode and the earnings they don’t pay, on an absolute level, are sufficient to grow the business. For example, Merck pays a 4.05% dividend right now and they just bought Schering-Plough for $41.1 billion in cash and stock. They paid a healthy dividend and were able to build their business.
  • The dividend stocks I’m looking at are all going to be stable blue chip companies with good dividend coverage. That is to say the stock price isn’t going to gyrate too much and their cash flow from operations can cover their dividends by a healthy margin. I’m not looking for growth, I’m looking for stability.

Finding Dividend Yielding Stocks

As I mentioned before, it comes down to dependability and coverage. The best place to start is with companies that have paid out a dividend for years and this Fool.com list [7] isn’t a shabby place to start. I don’t own any stocks on their “dividend dynamite” list but I think I might in the near future.

Another way is to simply buy a dividend fund. Vanguard has their Dividend Growth Fund (VDIGX [8]), with an expense ratio of 0.32%, a yield of 2.08%, and holdings in 49 different stocks. Fidelity’s version (FDGFX [9]) has an expense ratio of 0.62%, a yield of 1.90%, in 483 companies. A dividend fund gives you a little protection with diversification at the cost of an expense ratio.

Do you do any dividend investing? Do you have any tips and tricks for a novice like myself? Do you absolutely hate the idea of dividends?

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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/why-dividends-stocks-rock.html

[3] Rudyard Kipling’s If: http://www.bargaineering.com/articles/if-by-rudyard-kipling.html

[4] 2009 tax brackets: http://www.bargaineering.com/articles/2009-federal-income-tax-brackets-projected.html

[5] tax equivalent yield: http://www.bargaineering.com/articles/calculate-taxable-equivalent-yield.html

[6] tax equivalent yield calculator: http://www.bargaineering.com/articles/tax-equivalent-yield-calculator.html

[7] Fool.com list: http://www.fool.com/investing/dividends-income/2009/11/18/dividends-for-100-years.aspx

[8] VDIGX: http://www.google.com/finance?q=VDIGX

[9] FDGFX: http://www.google.com/finance?q=FDGFX

Thank you for reading!