Invest in the right company

October 24, 2001 Posted: 1112 GMT

By Humberto Cruz

CHICAGO (Tribune Media) -- Investing in companies with a history of increasing dividends has been a successful long-term strategy. But not all companies that pay little or no dividends are bad companies.

Humberto Cruz, a nationally-syndicated personal finance columnist, answered questions from readers about how to make sense of rates of return. He also answered a question about paying taxes on interest and dividends.

Question: I'm becoming very concerned about the lack of consideration many companies show toward their shareholders. They talk about increasing shareholder value but seem more interested in increasing management salaries, perks and benefits.

They cut or substantially reduce dividends, not because the company is losing money but rather to "invest in the company," buy back stock, etc.

It seems that this is done primarily to increase the value of management's stock options. Excessively large salaries, bonuses and buyouts are examples of taking money that should go to the shareholders.

I believe that a company truly interested in its stockholders should pay a regular dividend from its profits. If no dividends are paid, the only way for the shareholder to benefit is by selling shares at a profit. And the next buyer must do the same thing.

Obviously, this does not work indefinitely, as we're now finding out. My own criteria for investing now is to select companies that pay a reasonable dividend and have a pattern of increasing that dividend. This way, I can benefit from the company's success, and if it does well the stock price will also increase.

Answer: In response to your letter, I asked for a comment by Vita Nelson, editor of the Moneypaper newsletter, long-time advocate of dividend reinvestment plans and manager of the MP 63 Fund, which invests in 63 companies that offer such plans.

"The writer of the letter is correct, of course, about management that heaps excess rewards upon itself, in effect plundering the corporate treasury, often with the assistance of the board of directors," Nelson said.

She also said, "Ultimately investors must vote with their feet and abandon companies that are heading down such a destructive road. But it's also important to avoid lumping greedy management in with companies that pay small dividends, since the connection may only be coincidental."

While Nelson's newsletter and fund favor companies that pay and regularly increase dividends, she notes that when Congress lowered the long-term capital gains tax rate to a maximum 20 percent in 1997, it also increased the advantage of capital-gain income over dividend income.

Dividends are taxed at "ordinary income" rates, as high as 39.1 percent now and always higher than rates for long-term capital gains.

	FOR EXAMPLE
		A company that pays a dividend of 10 cents a share will have its share price reduced by 10 cents by that action.

Corporations also are aware of the "double taxation" of dividends – the company first pays income tax on its profit and shareholders are then taxed on the portion paid out in the form of dividends. Therefore, companies may try to provide returns more efficiently," Nelson said.

"Since other companies are limiting their payouts, there is less pressure to raise dividends in order to attract investors," she said. "The recent trend toward lower yields also tends to affirm management's judgment that higher dividend payouts may not be the best way to reward shareholders. And in a slower economy, where profits are harder to achieve, retaining more capital to fuel expansion is an additional consideration."

Nelson said that shareholders also need to consider the relationship between stock price and payout. Each time a dividend is paid, the stock price is reduced.

So, in effect, the shareholder, in choosing higher yields, elects to pay ordinary tax now on the dividend rather than tax on a possible gain at a later date, and at a lower rate.

"To the extent that the shareholder prefers a dividend payout, he or she is casting a vote of no confidence, as if saying to the company management, 'I don't believe you'll create higher value ... give me my money now' (less the ordinary-rate tax, of course)," Nelson said.

Companies also are realizing that share buybacks are a good way to increase shareholder value, Nelson said.

The same amount of corporate profit is taxed at the corporate rate, then divided by a lower number of shares outstanding, so earnings per share is higher.

"Naturally, though, the ideal situation is a company that increases earnings per share and the dividend rate each year, and we favor those companies," Nelson said. But it's worth noting that companies with a very long string of dividend increases, such as Johnson & Johnson (JNJ: Research, Estimates) and Emerson Electric (EMR: Research, Estimates), maintain a relatively low yield, she said.