Dividends in Mutual Funds

We have been discussing dividends with Paul Petillo, a regular contributor on MomsMakingaMillion Radio for the last several weeks. As we continue or series, we have five questions:
Could you recap briefly for our listeners what we have already discussed?

Our discussion about dividends has offered a brief overview of what they are: profits paid back to the shareholder of record, and how you can buy them directly: through direct stock purchase of through dividend reinvestment plans or DRIPs. By far, the easiest way to take advantage of what these companies offer shareholders is to spread the risk and the time you might take looking for them by using mutual funds.

When we look at mutual funds that pay dividends, what are we looking for exactly?

This group of mutual funds is often referred to as 'equity income'. They are stocks that provide income and fund managers in this space are looking for good stocks selling for less than what they perceive which means they are hunting for value and stocks that pay a dividend. Keep in mind, this was much easier to do just a few short years ago.

Why is that?

There was a tax advantage to these types of funds and in the pre-bailout economy, many companies were increasing their dividends because of it. Since then, many companies, particularly those with a financial component (like GE and GM) or businesses focused on the financial sector (such as Citigroup) have either suspended or reduced their dividend in response to those changes in fortune. Currently, there are about 296 stocks that pay a dividend of some sort. In fact, holding an S&P 500 index fund will net you a dividend yield of about 2.5%. That 2.5% is what equity income funds use as the number to beat.

Are all dividend paying stocks the same?

Not at all. There is a term for it: dividend payout ratio. In the thirties, this ratio was about 90% - that's roughly ninety cents for every dollar made was given to shareholders. Now it is about 30% or less. This is a good rule of thumb for investors. If your stock is paying more than 30% of their profits back to shareholders, this might be a sign of trouble (if you consider that this percentage has gone up while the share price, a vote of investor confidence has gone down). If it is paying less the 30%, the company might be overvalued by the markets or simply in too much trouble to pay enough of the profits to shareholders.

Any last thoughts?

Keep in mind that dividends are backward looking, reflecting profits from the past year. If companies cut their dividends because profits were down, raising or reinstating them might not happen until next year. A lot of companies are going to buy back shares of their own businesses in large part because they are still cheap and because doing so, increases the price of the stock by making less shares available.

Look for companies that have been able to increase dividends over a long period of time (like McDonalds (dividend payout ratio: 52%), Pepsi (dividend payout ratio: 54%), Kimberly-Clark (dividend payout ratio: 55%) or a mutual fund that has beaten the S&P500 average payout of 2.5% (Columbia Dividend Income 2.47%, Nicholas Equity Income, yield 3.12%)

Paul Petillo is the Managing Editor of Target2025.com