Stocks for Income

SIVY ON STOCKS from money.com
October 16, 2000

Selecting stocks for income

We all want a stock that will double overnight. But there's something to be
said for steadily rising dividends.

By Michael Sivy

"Show me the money" is the cry of income investors. They don't want to bet
on future earnings growth or higher valuations. They want safe, reliable
cash payouts that rise faster than inflation.

There's a good case for including income investments in any portfolio,
especially given the market's recent volatility. And there are plenty of
choices. But shares of companies that pay dividends have an important
advantage over many of the alternatives. Bond payouts don't increase over
time, for example, but dividends do rise for most income stocks.

Historically, blue-chip stock yields have averaged around 4%. And most of
the time they've ranged between 2.8% and 5.4%, with a few exceptional
periods. We're in one of those periods right now, with the yield on the S&P
500 well under 2%. Nonetheless, even in this market it's possible to find
stocks with yields of 3% or more.

You shouldn't focus on today's yield, however, and ignore everything else.
The dividend growth rate is equally important. A stock raising its dividend
6% a year will double its payout over 12 years and quadruple over 24. If
you hold long enough, even a stock with a modest yield could end up paying
out far more than you could earn with a bond.

To evaluate an income stock, you should consider the current yield and the
likely dividend growth. Since dividends usually increase more or less in
line with earnings, you can gauge a stock's long-term potential simply by
adding the growth rate to the current yield. If a stock has a 3.5% yield
and 6% annual earnings growth, for instance, its long-term return is likely
to average about 9.5%.

You can compare that total return estimate to the yield available on bonds.
If you figure that high-quality bonds pay as much as 7% or 8%, income
stocks will need potential total returns even higher to be top choices.
Many good utilities -- including electric, gas and water companies -- clear
that hurdle.

The big risk to any income investment is an upsurge in inflation. You
should therefore award extra points to any income investment that
incorporates an inflation hedge. Oil stocks and mining shares, for
instance, would benefit from any increase in raw materials prices and some
of them pay fairly high yields. Similarly, real estate investment trusts
profit from rising property prices and some REITs pay yields of 7% or so.
That's a whole lot more than you'll earn in a money-market fund.