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September 18, 2012

Thomas Huber David Giroux Sudhir Nanda Thomas Huber, manager of the Dividend Growth Fund. David Giroux, manager of the Capital Appreciation Fund. Sudhir Nanda, manager of the Diversified Small-Cap Growth Fund.

With ultra-low interest rates and bond yields putting income-oriented investors on the financial equivalent of a strict diet, many have turned to dividend-paying stocks to satisfy their hunger for yield. However, they now face the question of whether their new tastes will end up giving some of them a bad case of investment heartburn. Possible risks stem from stocks' volatility relative to bonds, potential dividend cuts, and changes now being discussed in Washington that might raise the federal tax rate on dividends.

The craving for equity yield is easy to understand: Interest rates on savings accounts and money market funds remain close to zero, while long-term Treasury yields have fallen to record lows—dipping below the dividend yield on the S&P 500 Index. (See chart below.) That hasn't happened since the depths of the 2008 financial crisis.

Meanwhile, stocks with dividend yields of 4% or higher still can be found in some traditional equity income sectors—such as utilities, telecommunications, and health care.

"Investors are looking for some sort of yield on their investments, and they're not finding it in the bond market and certainly not in the money markets," says Thomas Huber, manager of the Dividend Growth Fund. "So higher-yielding, dividend-paying companies have become an attractive alternative."

Dividend Yields Are Higher Than Treasury Yields
Ten-year and 90-day Treasury yields versus S&P 500 Index dividend yield through 6/30/12.

Ten-year and 90-day Treasury yields versus S&P 500 Index dividend yield through 6/30/12.

In reaching for yield, however, investors could be ingesting more risk than they bargained for. While high-dividend stocks historically have had below-average sensitivity to broad market movements, they're still far more volatile than investment-grade bonds or money market instruments.

High dividend yields also don't always stay high. A stock may have a high yield not because it is generating ample earnings and returning a hefty portion of that income to investors, but because its price has been beaten down by bad news or bad management. If that's the case, a painful dividend cut could be in the cards.

Plus, potential tax changes could have a negative impact. Dividends are currently taxed at a top rate of 15%—the same as long-term capital gains and much lower than the maximum rate on most other income (including interest). But that break is set to expire at the end of 2012, and there is no guarantee it will be extended.

The Price of Yield

So far, these potential pitfalls haven't curbed investor appetites for yield. The demand for high-dividend-paying stocks has pushed valuations higher, both in absolute terms and relative to non-dividend stocks. (See chart below.)

"Any way you look at it, high-dividend stocks are expensive," warns David Giroux, manager of the Capital Appreciation Fund. "They're expensive relative to history, relative to the fundamentals, and relative to the market."

If historic valuation patterns were to reemerge, high-dividend stocks could underperform, Giroux says. Investors got a taste of that in the first quarter of 2012, when growth expectations improved and lower-yielding sectors rebounded more strongly.

That doesn't mean investors need to cut out high-yielding stocks entirely. Giroux says he is taking a "surgical approach" and is still finding reasonable yield opportunities in the health care and consumer nondurables sectors, among others.

Also, if recent market weakness continues, dividend-paying stocks may offer more downside protection than the market in general.

Seeking Dividend Growth

Investors with less immediate need for income may want to shift their focus from stocks with high current dividend yields to those that can potentially increase their dividends over time, Huber suggests. "The valuation differential between dividend yield and dividend growth is quite wide, so there are still good opportunities there," he says.

T. Rowe Price analysts cite several reasons to expect a relatively favorable environment for dividend growth:

  • The technology sector: A decade ago, less than 20% of S&P 500 technology stocks paid dividends, according to FactSet, a financial data provider. By the end of 2011, more than half did. As a result, the sector's contribution to total dividend growth is also rising quickly.
  • The financial recovery: Most big banks are still paying only a fraction of their pre-2008 dividends. However, a growing number have received regulatory permission to restore or raise payouts. The financials sector traditionally has accounted for a hefty share of total dividends, so assuming another crisis can be avoided, that trend should augur well for future growth.
  • Low payout ratios: The share of earnings that corporations pay out in dividends is well below the long-term average, as dividend increases have lagged earnings growth since the bottom of the recession. At the end of 2011, the payout ratio for the S&P 500 was just 30.5% versus a 35-year average of more than 46%.

"Current payout levels would seem to leave plenty of room for dividend growth," Huber says. "But a lot still depends on the direction of the economy and earnings."

Taxing Issues

Then there is the tax cloud hanging just over the horizon for dividend investors: the looming expiration of the investment tax cuts passed in 2003. Some analysts have warned that allowing tax rates on capital gains and dividends to return to higher, pre-2003 levels could trigger a major market decline.

Higher tax rates could certainly be detrimental for dividend-oriented investors, but fears of a dramatic sell-off appear exaggerated, given that at least two-thirds of S&P 500 dividends—and half of all U.S. equity dividends—are paid to tax-exempt or tax-deferred investors, such as pension funds and investors in individual retirement accounts and 401(k)s, according to Standard & Poor's.

To the extent that tax-exempt or tax-deferred investors are driving the market, tax rate changes should have less impact on valuations, says Sudhir Nanda, manager of the Diversified Small-Cap Growth Fund and T. Rowe Price's director of quantitative equity research.

In any case, studies show that past tax rate changes—both up and down—appear to have had only modest effects, Nanda says, to the point where it's hard to distinguish those changes from other contemporary events, such as the 1990s technology bubble or the recovery from the 2002 bear market.

Higher tax rates could induce companies to cut dividends or slow their growth, reducing both payout ratios and yields.

However, "companies don't like to cut dividends because that typically is viewed very negatively by the market," Nanda says. "Investors tend to reward predictability, and companies with stable, growing dividends are perceived as high quality. I don't think many companies would want to put that at risk."

Relative Valuations for Dividend Stocks Are High

Price/earning (P/E) ratios for high-dividend and non-dividend-paying stocks in the Russell 1000 Index of large-cap U.S. stocks, based on forward 12-month earnings estimates through 6/30/12. High dividend reflects the top 20% of dividend-paying stocks by yield.

Price/earning (P/E) ratios for high-dividend and non-dividend-paying stocks in the Russell 1000 Index

Focus on Quality

Dividends are a critical component of equity performance. Over the past three decades, reinvested dividends accounted for more than half of the total return on the S&P 500 Index. They're also a welcome source of current income—at a time when investment yield is hard to come by.

However, investors may want to look at more than just yield when assessing equity opportunities.

In the current uncertain environment, a strategy that seeks attractively valued companies with records of strong dividend growth might make more sense, Huber says, particularly if it is grounded in close attention to company fundamentals and long-term performance.

"Companies with the ability to grow dividends over time tend to be durable businesses with strong cash flow and relatively predictable earnings," Huber says. "So you're more likely to get a return on your investment year in and year out."

Share prices can fall because of weakness in the broad market, a particular industry, or specific holdings. Funds with an emphasis on dividend-paying companies could result in significant investments in large-capitalization stocks. At times, large-cap stocks may lag shares of smaller, faster-growing companies. Also, a company may reduce or eliminate its dividend. Efforts to buy stocks that appear temporarily out of favor carry the risk that a stock or group of stocks may remain out of favor for a long time and may continue to decline. Investing in small companies involved greater risk than is customarily associated with larger companies. In addition, growth stocks can have steep price declines if their earnings disappoint investors.

Diversification cannot assure a profit or protect against loss in a declining market.

An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although they seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

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