When it comes to stock dividends, bigger may not always be better.
That's a warning investors ought to heed as they mull over the effects of the dividend tax cut Congress approved last week, financial pros say.
The maximum federal tax rate on dividend income will drop to 15% from what had been 30% or higher for many investors. The new rate will be the lowest levied on dividends since before World War II.
The rate cut is expected to make dividend income far more appealing to investors. With yields on money market funds and high-quality bonds at generational lows -- and that interest still taxed at regular rates as high as 35% -- many investors may be tempted by annualized dividend yields that top 3% on many common stocks, and in some cases exceed 6%.
But investors who focus exclusively on the highest-yielding stocks may be buying shares whose dividends are in jeopardy, experts say. A high yield can be a warning that the market expects the company to cut its payout.
Also, investors who reach for high current income on common stocks may be giving up heftier returns over time by missing companies that pay less now but are likely to raise their dividends on a regular basis.
Because the top tax rate on long-term capital gains also has been reduced -- to 15% from 20% -- some money managers say the stocks that could be helped the most by the tax changes are those that have good prospects for growth as well as income.
"Growth-and-income stocks benefit from a double whammy," said Steve Colton, manager of the Phoenix-Oakhurst Growth & Income fund in Scotts Valley, Calif. "The capital gains rate goes down, so the appreciation is taxed at a lower rate, and of course, the dividends are taxed at a much lower rate."
One example he likes is Citigroup Inc. The financial giant's stock price is up 11% so far this year, to $39.09 on Friday.
As for dividends, Citigroup's annual payment per share is 80 cents, giving the stock a yield of 2% -- which is above the 1.8% average yield of the blue-chip Standard & Poor's 500 stocks. (The yield is calculated by dividing the dividend by the stock price.)
Citigroup has raised its dividend every year for the last five years. The payment was lifted 11% in the first quarter, to a quarterly rate of 20 cents.
An investor who paid $24 for Citigroup stock at the end of 1998 is earning a yield of 3.3% on those shares, based on the current dividend. That illustrates one of the key benefits of rising dividends, money managers say: Unlike with a fixed-rate bond, a stock's dividend yield can increase over time.
"This is the first chance to invest in a growing stream of 15%-taxed income," said Joe Keating, chief investment officer of AmSouth Bancorp in Birmingham, Ala. "That's very positive for investors."
Many portfolio managers say a company with a dividend yield in the range of 2% to 5%, and with healthy growth prospects, may be a better choice than much higher-yielding stocks.
"We never stretch for yields," said George Mairs, manager of the Mairs & Power Growth fund in St. Paul, Minn. "When companies pay really high dividends you don't get much earnings growth. Still, we kind of feel like we're entitled to at least a 2% annual yield, which can add a lot to the total return over time."
Chris Wiles, co-manager of the Strong Large Company Growth fund in Milwaukee, concurs, noting that high-dividend payers can be risky.
"My experience over the years has been that you're better off chasing dividend growth rather than dividend yield," Wiles said.
Many investors are "intrigued" by Altria Group Inc.'s dividend yield of 6.1%, he said, referring to the tobacco firm formerly called Philip Morris. "But you have to ask yourself how stable that dividend is. It might be just a matter of time before some state or some court says, 'If you've got enough money to pay your shareholders a 6% dividend, you can afford to pay more legal damages.' "
Over the last decade, investors in many electric utilities have learned the hard way that big dividend payments often are at risk of being cut if a company gets into financial trouble.
Colton said a modest "payout ratio" -- the percentage of per-share earnings paid out in dividends -- can point to a company that will be able to raise its dividend in the future if financial performance is strong.
Citigroup, for example, is expected to earn about $3.22 a share this year, according to Thomson First Call. With a dividend of 80 cents a share, the company is paying out 25% of its profit as dividends.
By comparison, some utilities pay out three-quarters or more of annual profit in dividends, which may leave little room for significant increases. The average blue-chip stock's payout ratio was about 30% of operating profit last year, according to S&P.