• Share

PRINT

Glance at 2010 returns and it’s easy to see why mutual fund investors might be tempted to chase the stock market’s hot spots.

Thinking small paid off big last year. Funds specializing in stocks of smaller companies gained an average of 23 percent, compared with 13.6 percent for large-cap funds, according to Lipper Inc.

But avoiding those big stocks could mean missing out on one of this year’s best opportunities. There’s growing potential in dividends, and they’re more likely to be paid by larger companies. That’s because smaller companies generally reinvest profits in expanding their business.

A couple of reasons why dividend investing is likely to pay off this year: An extension of the Bush-era tax cuts means Uncle Sam will continue treating dividend income favorably.

And corporate America is sitting on hoards of cash. During an economic recovery, corporations will be more inclined to raise their dividend payouts.

“Traditional dividend investing is back in style as investors look for total return, stability and income,” said Howard Silverblatt, a Standard & Poor’s analyst. “2010 was a very good turnaround year.” Yet there’s still a lot of ground to make up before payouts reach their pre-recession levels.

How dividends work

Dividends are the quarterly distributions that companies pay to shareholders. In turn, mutual funds holding dividend-paying stocks pass that money on to their investors.

Dividends are important because historically they make up more than 40 percent of the total return of the Standard & Poor’s 500 index, with the rest coming from rising stock prices.

Large-cap stocks — generally, those with market values of more than $3 billion, the cutoff for stocks in the S&P 500 — are the first place to look for dividends. About 75 percent of the stocks that make up the index pay dividends. Only 39 percent of smaller companies below the cutoff pay them.

Here are six factors to watch:

1. A two-year tax holiday: For much of 2010, it appeared likely that taxes would rise on dividend income. Since 2003, dividend taxes have topped out at 15 percent. The extension of the Bush-era tax cuts means that historically low rate will remain for another two years.

Without the tax deal signed into law last year, dividend investors in the top income bracket would have faced a rate of nearly 40 percent. For top earners, the extension means a savings of nearly a quarter on every dollar of dividend income they generate in a taxable account. Investors will save nearly $75 billion over two years, Silverblatt estimated.

2. Payouts expected to rise in 2011: The economic recovery is gaining strength, leaving companies more confident that they can afford to partially restore previous dividend levels. This comes after a tough two years when dividend investors took a huge hit as companies slashed and, in come cases, eliminated dividends to ride out the recession.

Announcements of dividend increases rose 45 percent in 2010 compared with 2009. Instances of companies reducing payouts fell 82 percent, according to S&P.

Silverblatt expects these trends to accelerate in 2011 as companies spend more of their recently expanded cash coffers.

“Companies are going to move quickly to demonstrate that they are well into the recovery mode, and dividend increases will be their early tool of choice to ensure that this happens,” he said.

3. Spring could be a bonanza: Companies are preparing to report 2010 financial results. With the uncertainty about dividend taxes settled for the next two years, expect a surge of announcements by companies planning to increase payouts in the spring.

That could inspire investor confidence and lift stock prices, said Joanna Bewick, co-manager of the Fidelity Strategic Dividend & Income Fund (FSDIX). Such announcements “send a long-term signal to investors, saying ‘We think we have a sustainable business model, and we can afford the dividend increase over the long term.’”

4. Dividends will recover, but slowly: Although the dividend outlook is improving, it’s important to maintain perspective. Dividend cuts were so deep following the stock market meltdown that Silverblatt expects it will be 2013 before payouts return to 2008 levels. And that’s only if the economy cooperates.

One example: General Electric said in December it would boost its quarterly payout by 2 cents to 14 cents per share. Back in 2008, the payout was 31 cents per share.

5. Bank stocks will continue to lag: Stocks of large banks are traditionally big dividend payers. But the market meltdown changed that. Banks were hurt more than most stocks, because the recession was driven by subprime mortgage troubles and a credit-market freeze.

They’re recovering more slowly than other areas of the economy — one reason why funds specializing in financial stocks posted the third-smallest average return in 2010 (11 percent) among 21 stock fund categories that Morningstar tracks.

6. Dividend income could complement bond income: Fear over rising interest rates has cut into bond returns and reduced the prices investors are willing to pay for many types of bonds. Key reasons include improving expectations for the economy, and fear of long-term inflation.

Those factors make dividends potentially attractive to investors looking to trim bond holdings and find alternative income sources.

Historically, Bewick said dividend-paying stocks have fared better than bonds during rising inflation. It’s one reason her $815 million fund has recently increased its stake in dividend-paying stocks, particularly energy stocks like top holding Exxon Mobil.

In a slow economic recovery, typically steady dividend-paying stocks, “could make up a greater proportion of investors’ overall returns than in the past,” she said.

— AP