<THE FOOLISH FOUR>

What to Do with Dividends
by Bob Price
([email protected])

Houston, TX. (October 27, 1998) -- A reader wrote about the Fool 9 article last week and indicated that I said, "the Dow 30 purchased on an equal dollar basis with shares reinvested." That didn't make a lot of sense. It should have said, "the Dow 30 purchased on an equal dollar basis with dividends reinvested annually." It's been corrected, so if you follow the link at the start of this paragraph you will not see the error. However, it did bring up the question of accounting for dividends and what to do with dividends in your Dow investing.

Taxes on Dividends

All the Dow approaches generate dividend income, since all the Dow stocks pay dividends. If you have your Dow strategies in an IRA or other tax-sheltered account, this is not a big issue. In a taxable account, though, dividends are ordinary income. You need to keep track of this income and pay taxes on it. Typically, your broker will send you a yearly statement showing your dividend income.

Reinvesting Dividends

For the most part, results shown around Fooldom state returns based on just letting the dividends sit in the account until the next annual cycle, at which time they are assumed to be used to buy new stocks (along with the proceeds from any sales of your Dow stocks). In practice, you will usually get a bit of income on that cash, which is also not shown in the results. On the other hand, we aren't showing commissions, either. For some lucky people, these two effects may offset one another.

Your broker may have an option to reinvest dividends at no extra commission. I have not seen or done -- yet --an analysis of whether this will increase your total return over the simple strategy in the last paragraph. If you have your Dow strategy in an IRA, and your broker offers the option, I'd suggest you consider doing it.

However, in my taxable accounts, because of the taxes, I do not do this. If you buy a stock at the start of the year and reinvest dividends along the way, at the end of the year if you sell, your accounting is more complicated. Even if you arrange things so that it has been held for a year and a day, you won't have long-term gains on the small amounts that have been bought along the way. You'll have to account for these as separate purchases, have individual Schedule D entries for each, and pay taxes on them. My favorite approach in a taxable account is to use a small amount of margin so that your dividends have been used in advance to buy stock. Check out the hyperlink for details.

The Advantage of Dividends

So why put up with dividends? We have to pay taxes on them, they're extra work, and phooey, there are lots of stocks we can buy and hold that don't pay dividends. Actually, most of the portfolios in Fooldom aim to buy and hold stocks for the long haul, with the Cash-King portfolio probably having the strongest emphasis on this. But the Cash-King portfolio made a point of buying the RP4 stocks as well. Why?

As we mentioned above, if you're going to buy a Dow 30 stock, you're going to receive a dividend. Historically, you could match the returns of the Standard & Poor's 500 (and thus crush the returns of over 80% of all mutual funds) by simply buying all 30 Dow stocks. If you buy the Dow 30 stocks that pay high dividends, you get the added bonus of downside protection.

For instance, as I write, J.P. Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %> is the highest yielding Dow stock, paying over 4%. [In the interest of Foolish disclosure, I own a few shares of J.P. Morgan.] Unless J.P. Morgan gets in such serious trouble that they have to cut their dividend (which Dow 30 companies very seldom do), you can be fairly certain that their price isn't going to go down too much more. If, for instance, the price were cut in half, you'd have an 8% yield. This isn't likely to happen -- this would be higher than the typical bond yield in a stock with potential for price appreciation. The price will not fall so far, keeping the yield at a reasonable level.

As regular readers of this area know, the highest yielding Dow 30 stocks have in fact routinely crushed the Dow Jones Industrial Average's return. So those dividends are worth a little trouble.

Current Dow Order | 1998 Dow Returns

10/27/98 Close
Stock  Change   Last 
 -------------------- 
 UK   -1  1/4   37.94 
 IP   -1  1/16  44.69 
 MO   +   1/2   50.75 
 EK   +1  1/2   74.63 
 
 
                    Day   Month    Year 
         FOOL-4   -0.41%  -2.40%   8.18% 
         DJIA     -0.78%   6.67%   5.79% 
         S&P 500  -0.65%   4.75%   9.78% 
         NASDAQ   -0.43%   1.40%   9.38% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  206 Eastman Ko    60.56     74.63    23.22% 
  12/31/97  276 Philip Mor    45.25     50.75    12.15% 
  12/31/97  289 Int'l Pape    43.13     44.69     3.62% 
  12/31/97  291 Union Carb    42.94     37.94   -11.64% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  206 Eastman Ko 12475.88  15372.75  $2896.88 
  12/31/97  276 Philip Mor 12489.00  14007.00  $1518.00 
  12/31/97  289 Int'l Pape 12463.13  12914.69   $451.56 
  12/31/97  291 Union Carb 12494.81  11039.81 -$1455.00 
  
  
                              CASH    $754.73 
                             TOTAL  $54088.98