Are These Dividends For Real?

By Sham Gad | May 21, 2010 AAA

Generally speaking, dividends are a good thing. However, the double taxation that dividends are exposed to does not sit well with many. Dividends are taxed at the corporate level, and then again on the personal level when they are paid out to investors. So yes, in this regard, dividends may not be the optimal capital allocation decision. Yet, the majority of the time, dividends are indeed a valuable use of corporate capital.

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Capital Allocation
The truth of the matter is that a substantial portion of long-term capital gains comes from dividend payouts. And using company profits to pay dividends to stockholders creates discipline among the companies that issue them. Dividends are cash payments, and cash can not be manipulated. The payment of a quarterly dividend suggests that the company is generating the cash necessary to pay it. Also, managers are aware that many investors will dump shares if the dividend is eliminated. This knowledge reduces the likelihood that management squanders the cash on poor acquisitions.

On the flip side, should a dividend-paying company eliminate or suspend the dividend, that serves as a warning to investors that operations might be. So in weighing the pros and cons, it appears that the advantages of dividends outweigh the disadvantages. (For more, see The Power Of Dividend Growth.)

Three Huge Yields
Linn Energy (Nasdaq:LINE) is an oil and gas master limited partnership with an amazing 10% dividend yield. MLP's are in the business of owing stable oil and gas properties that produce stable cash flows. To maintain their tax efficient status, MLPs pay out most of their cash flows out to unit holders. Linn's yield is only half the story. The company also has one the best hedge books in the business. Over the next three years, nearly 100% of Linn's production is hedged at oil and gas prices at about current prices. This hedge book, along with the yield, makes Linn one of the most attractive MLPs in the business. Kinder Morgan Energy Partners (NYSE:KMP) yields under 7% without the quality hedge book.

If you're not averse to a company selling cigarettes, Altria (NYSE:MO) may be the most dependable dividend-paying stock in the market today. For decades, this titan has consistently paid a top tier dividend and delivered impressive total returns, year in and year out. Today's yield of 6.5% is among the best and the safest. And with a P/E ratio of 13, shares are cheaper, relative to overall market index.

With a 4.4% yield and a $16 share price, Pfizer (NYSE:PFE) looks very attractive, from both angles. Despite the patent loss on Lipitor in the next couple of years, Pfizer has a lot of drugs in its pipeline, even more so with the recent acquisition of Wyeth. And while you are waiting for this to happen, your earning nearly 5% on your investment. Pfizer is $130 billion company that earned over $15 billion in free cash flow in 2009.

The Bottom Line
Dividends are real, and they can be counted. A stock that yields 4% a year need only appreciate by 5% per annum over the long-run to produce a market-beating return. So, ignore dividends at your own expense. (For more, see Why Dividends Matter.)

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