Dividends Are Back in Style

One of my favorite finance professors, Dr. Tim Johnson, used to tell me that back when he was taking business school classes, his textbooks read: Because stocks were riskier than bonds, they had to yield more.

While I can currently find some stocks that yield more than a Treasury -- or even an investment-grade -- bond, this is not typical. The dividend yield on the S&P 500 declined precipitously from about 6% in 1982 to 2000, where it bottomed at about 1.1%. It has come up of late, courtesy of lower stock prices and legislation that lowers taxes on dividends. But we are far from the highs in dividend yield seen in the past. In the early 1950s, for instance, the S&P 500 index yielded about 7%.

Where are those dividends now?
According to Standard & Poor's, the average dividend yield from December 1936 through March 2009 for the S&P 500 -- which takes both low- and high-dividend paying periods -- is 3.814%. The current 12-month trailing dividend yield is 3.42%, as of March 31. Keep in mind that over the same period, the dividend yield component made up 44% of the 9.51% annualized return of the S&P 500.

In doing research for my book, I came up with three long periods in the last 100 years of U.S. stock market history that produced no capital gains for the major indexes. Today, stocks are currently trading where they were about 12 years ago. The conclusion was that one should look for unorthodox ways to make money because indexing can be pointless for long periods of time. Focusing on dividends is definitely one way to tackle this problem.

Given that, here is a list of stocks in the S&P 500 currently giving a dividend yield of 7% or higher:

Source: MSN Money. *In billions.

The highest S&P 500 yielders
Screening for stocks just by looking at the dividend yield can be a recipe for disaster. Usually, the yield is highest just before the dividend goes bye-bye, as the price often declines in anticipation of that cut. Notice from the above table that General Electric made a dividend cut. The table is showing a ranking based on trailing dividends, regardless of any recent cut. But GE has turned out to be a pretty good stock to hold -- despite the dividend cut -- as the economic data has been improving, and GE is leveraged to economic recovery. In this case, its dividend cut turned out to be a perfect buy signal.

I have highlighted both Reynolds American and Altria as companies with sustainable dividends. Both stocks have come down courtesy of new tobacco taxes and massive fund outflows in 2008, but both have sustainable payouts.

Careful with REITs
You will note that there are three REITs in that table -- Equity Residential, HCP, and Health Care. Approaching any REIT in the current environment should be done with extra caution. There is a serious issue with commercial real estate, and I can see how the commercial real estate market may turn out to be the next shoe to drop.

Delinquency and default rates for securitized commercial real estate loans -- like office, retail, industrial, and hotel properties -- are likely to rise above 6% by the end of the year, according to one report. This is more than triple the default rate 1.76% in the first quarter and continues a rising trend as they were down at 1.14% in the fourth quarter and 0.8% in the third quarter of 2008. Such securitized loans represent about 21% of the $3.5 trillion commercial real-estate debt market -- a huge number.

While the three REITs above may weather the storm, I would stay away from retail REITs in general -- no matter how tempting the yields -- as retail vacancies are expected to reach 11.8%, the highest level since at least 1980, according to that same report. This doesn't surprise me and probably shouldn't surprise you if you've been to a mall recently. Two weeks ago I visited a middle-class Cincinnati suburb shopping mall, and it felt like a ghost town. Between one-third to one-half of the storefronts were empty, and I was the only customer in a Tommy Hilfiger store, being helped by both assistants. (Tommy Hilfiger customer service has definitely gotten better courtesy of the recession!)

Dividend yields tell only a part of the story
Dividend investors have to do more homework than just looking at dividend yields. A rapidly deteriorating fundamental picture -- as was the case with GE and will likely be the case with many REITs -- can push a company to cut its dividend despite a seemingly reasonable payout ratio.

Think about that the next time you see a juicy yield.

More on market issues:

• Long-Term Investing Doesn't Work
• The Next 3 Dividend Dynamos
• The Next 3 Dividend Burnouts