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Investing in stocks for income.

In today's low interest rate environment, income-oriented investors are being forced to look beyond Certifications of Deposit and bonds. One excellent source of income that should not be overlooked is common stocks.

At first glance, this may seem like a strange suggestion. Most consider stocks to be speculative investments that are best suited for achieving growth and capital gains. What they may not be aware of, however, is that many stocks pay large cash returns, or dividends. These dividends are not only competitive with current interest rates, but they often increase annually, something no C.D. or bond ever does. In fact, a portfolio of dividend-paying stocks can provide investors with increasing income -- a valuable inflation hedge.

Let's take a look at how this works. In the early years of most corporations, all earnings are needed to finance the growth of the company. As their growth slows, many companies find that they produce more earnings than can be reinvested in the business. The excess earnings are paid out in cash to the shareholders in the form of dividends. Each shareholder will be paid a specified dividend. The more shares an investor has, the larger the amount of dividends he or she will receive.

Every three months, the board of directors meets to decide if a dividend will be "declared" for the upcoming quarter, and how much the dividend will be. Once a company starts paying a dividend, the directors will be very reluctant to reduce or eliminate it, as they know shareholders are relying on it as income.

As time passes, it is natural for growth to continue to slow, further reducing the need for retaining earnings in the corporation. This will provide growing amounts of cash for increasing the dividend. The more mature a company, the more likely it will pay a large dividend. Risk of a cut in the dividend will come during adverse economic conditions, i.e., a recession or when the company reaches a prolonged period of decline.

What should the income-oriented investor look for in dividend-paying stocks? The first key attribute is a long, uninterrupted history of profitability and dividend payment.

When searching for companies that always seem to produce profits and have paid dividends, you will quickly discover that some industry groups will have many companies that qualify. Other industries will have none.

Foremost among the great dividend-paying industries are utilities. This only makes sense, as utilities occupy a unique business niche. In most circumstances, they have a monopoly in their service area. The major constraint on their profitability is a regulatory commission that limits how much they can earn, but also assures them of a specified profit if they perform successfully.

A second attribute of importance is how often the dividend is increased and by how much. Some companies will increase their cash payments more regularly than others, or by a greater amount. The ideal stock should increase its dividend every year.

There is a convenient source of information to help you find these ideal stocks, Moody's Handbook of Dividend Achievers. Each year since 1979, Moody's Investors Service has compiled a list of the companies that increased their dividend each year for at least 10 consecutive years. The stock with the longest record -- 48 years -- of increasing dividend payments belongs to a grocery chain. The highest rate of increase for the last decade was a toy company whose dividend grew 35.2 percent per year. The Valueline Investment Service also has tables of successful dividend payers.

But investors should not assume these lists will guarantee successful investments. Things change constantly in the investment world, and some of these companies will not be listed in next year's handbook.

A final criteria to consider is called the dividend pay-out ratio. This is a calculation of how much of the current earnings are being paid out as dividends, important because it is an indication of how much room there is for future dividend increases. A company that already pays out more than 90 percent of its earnings will have more difficulty increasing dividends than a company that only pays out 50 percent.

Of course, there are many other factors to be considered. The major lesson to be learned is not to overlook stocks as a major source of income. The right stock can provide a secure stream of rising income for many years into the future.

Robert Green is a financial consultant with Shearson Lehman Brothers in Anchorage.
COPYRIGHT 1993 Alaska Business Publishing Company, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Green, Robert
Publication:Alaska Business Monthly
Date:Jul 1, 1993
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