It’s been a busy summer and it occurs to me that a few of you may have missed the very interesting article entitled Rising Interest in Dividends in the current issue of the Journal of Indexes. From the name of the publication, you probably wouldn’t be surprised that the article compared various indexes developed for tracking the performance of dividend-paying stocks. A question left unanswered is whether dividend-paying stocks have been a good investment or might be in the future, so I thought I’d take a look.

Dividends and interest are the two most common ways investors can receive income from their investments. Investors who loan money to a company, bank or governmental unit receive interest in exchange. Unlike bond interest payments, dividends don’t involve a contract to pay a certain amount for a certain period. Instead, they offer a way for the company’s board to share its success with the investors who own it. One of the values of a dividend, then, is its indication of the ongoing stability of the company.

In addition to raising most of the money required to keep the government functioning, taxes are also used to influence social policy. For example, prior to 1986, all interest paid was deductible for tax purposes in an effort to help the economy grow. After the Tax Reform Act passed that year, only mortgage interest remained deductable. This change was made to increase tax revenues while assuming that continued subsidizing of home purchases was required to keep the nation’s economy on track.

Over the years, investment income has been taxed in various ways with distinctions often being made between short- and long-term gains. Believing that investing for longer periods should be rewarded, longer-term gains have been awarded lower tax rates while short term gains were taxed as regular income. The 2001 Economic Growth and Tax Relief Reconciliation Act made significant changes in the way retirement plans are handled and also added preferential treatment of dividends, allowing them to be taxed at the lower, long-term gain rates.

The entire law, known as EGTRRA, is due to expire at the end of this year, meaning 2011′s dividend earnings are scheduled to be treated differently. For better or worse, the mortgage interest deduction will remain but the reduced tax rate for dividends is due to be eliminated. Since tax rates are set to rise - unless election year rhetoric takes over - are dividends still of value? That’s a question I’ve been considering on behalf of my clients and I believe the answer continues to be yes.

Beyond their value in confirming a company’s stability, dividends are not fixed in the same way bond interest rates are. Years ago, retirees were advised to sell their stocks and buy bonds as a means of assuring their income. Since Americans are living much longer now, that advice has become somewhat dated. Those who buy bonds counting on a guaranteed level of income are likely to become increasingly uncomfortable as inflation forces prices higher during their lifetimes. Dividends are often increased over time, so they offer at least the potential for a rising income stream into the future.

Dividends obviously provide income to shareholders but there’s an additional benefit which accrues to the owners of companies whose dividends are increased. For whatever reason, investors tend to associate a dividend percentage with a company’s stock. Although stock prices rise and fall for many reasons related to various company and market activities, the share price of those companies which increase their dividends has a tendency to rise too, keeping the percentage about the same. This provides a double value to the company’s investors.

After twenty-one years in the world of financial planning and investments, I have learned that no single answer can be the right one every time. I see that Initial Public Offerings for tech stocks are back in the news as if the crash of 2001/02 never happened. Investors in search of a more conservative approach to growth might wish to consider dividend-paying stocks as an alternative. With bond interest rates at generational lows, dividend-paying stocks might also be a sensible option for those investors in search of income. Dividend-paying stocks certainly aren’t the answer to every investment question but they remain one of the most valuable tools at our disposal.

Growing up in Indianapolis, I knew very little about what went on outside the city limits and absolutely nothing about farming. When I worked as a stock broker in Logansport, though, I had several farmers as customers and began to learn about their lives. To a person, they loved the land. Most would never consider leaving it, even though it can be a demanding and sometimes uncertain way to make a living.

Most of my customers had learned farming from their parents and grandparents but today, Purdue University’s College of Agriculture offers more than forty agriculture-related majors and a similar number of graduate programs. Regardless of whether a farmer is college-educated or learned the trade growing up on the land, one of the most basic decisions which must be made is when to plant. Corn is Indiana’s number one agricultural commodity with Hoosier farmer’s planting about six million acres of it every year. Although the planting season varies with the area of the state, it is commonly planted in mid-spring and harvested in early fall. Stretching my understanding of farming to the limit, here’s a question: After harvesting an unusually good crop, do you suppose a farmer would seriously consider replanting corn in October since it had done so well from May to September? After all, it worked once so maybe it would again.

As unsound as this approach might seem, many individuals make investment decisions using just that logic. Since most people haven’t had the education and/or don’t have time to dig into the details, recent performance becomes the primary reason for selecting an investment. In fact, the number of stars in their ranking often takes precedence over all other factors.

Many investors don’t realize that the investing climates can change, just as weather does for farmers. A current example is the huge movement of investment dollars into bond funds. Readers of my recent teeter-totter article will remember that as interest rates fall, the value of the bonds themselves rises. As we’ve watched rates decline to nearly zero the past couple of years, it’s no wonder that bond funds have been very successful, generally outpacing stock funds in 2009 and the first half of 2010. Since many people were taught that bonds are safer than stocks and the category has been doing so well, why not buy more?

In fact, that’s exactly what an enormous number of investors have done. Year-to-date, individuals have withdrawn over $40 billion from stock-oriented funds and invested $160 billion in bond funds. With rates currently at generational lows, which way are they most likely to move? If it’s further down, bond funds will continue to do well, earning additional gains from falling rates. On the other hand, if rates go up, investors could very easily lose more through falling bond values than they earn from today’s low interest rates. The newest bond fund buyers will probably hold onto their investment to see if the reversal is just temporary, since recent results have been the opposite. Eventually, though, history shows us that investors will begin to sell those funds, requiring managers to sell individual bonds. This, of course, forces prices down further and leads to greater losses for all remaining share owners.

Commentators have a way of projecting the present situation far into the future, frequently making forecasts based on a continued orderly progression along the current trajectory. As regular readers know, our approach to investing is pretty much the opposite. We take a very broad look at the world’s economies, searching for opportunities which may be exploited. I have studied hundreds of years of interest rate data and know that rates move in cycles, meaning they’re almost certain to rise again. That may make new investments in individual bonds more appealing but it will certainly have a negative effect on that $160 billion in recent fund purchases. Just as we reduced our clients’ exposure to tech stocks in the late 1990′s, we have been adjusting their bond fund holdings for the past twelve months.

Being a city boy, I know even less about duck hunting than I do about farming but I’d like to close this article with an aphorism that may help illustrate my point. Rather than aiming for where the duck was (considering only past performance) or where it is right now (depending on the most recent star rating), a hunter needs to aim where the duck will be. That offers the only chance to have duck for dinner. Duck hunting and investing are alike in that way - even when the future can’t be known with certainty, there’s little point in aiming at the past. That simple illustration is a pretty good definition of Warren Ward Associates’ investment approach and it’s one we recommend to all investors, clients or not.