Dividends (l): the return of the cash dividend

How dividends come to be

Company managements are stewards of the capital that the company owners, the shareholders, have placed in their hands.  One of the jobs of management is to decide what to do with the cash the business generates.

There are two main choices:

–reinvest the money in the business if profitable opportunities to do so can be identified, or

–return the money to shareholders.

The return typically takes two forms:

–periodic payment of cash dividends to shareholders, or

–stock buybacks (a more dubious alternative, in my opinion).

“double taxation”

In many countries, including the US, cash dividends are subject to what is called “double taxation,” meaning that although the dividend is paid out of the money that’s already been taxed at the corporate level, the recipient is also required to pay income tax on the amount received.

Corporate managements in recent years have preferred to have stock buybacks rather than cash dividends, citing the avoidance of double taxation as a reason.  I find this a bit disingenuous.  Many times, companies use the buybacks to soak up (and obscure the negative effect on ordinary shareholders of) new stock being issued to managers through stock option programs.   If you watch the money trail, the cash leaves the corporate treasury and winds up in the pockets of corporate executives.

Forty-somethings could care less about dividends

For the past twenty years or so, investors in the US have have worked up virtually no interest in stocks for their dividend-paying ability.   How so?  The Baby Boom was (relatively) young and interested in making its money grow fast, that is, in capital gains.  The coupon on government bonds was over 7% until the internet bust, and interest rates were steadily falling as the Fed drove inflation out of the economy.  So T-bonds were the natural alternative for individuals desiring income, offering high yield as well as the chance of capital appreciation.

In part because of this, stocks of companies whose main virtue was the ability to generate steady income fell to low price levels.  Many were taken out of the public equity market–first, in a wave of junk bond-related acquisitions, and more recently by private equity.

Now, fast forward to the present.

For retirees, it’s a different situation

The Baby Boom is reaching retirement age and starting to shift its investment preferences toward income generation rather than making its capital grow.  Long-dated government bonds are yielding half what they were ten years ago, and have in them the potential for capital loss as/when interest rates begin to rise from the current crisis-low levels.  Money market funds yield close to zero.

For the stock market, too

On the other hand, many integrated oil companies, utilities and telecom firms have stocks that yield about as much as the 30-year T-bond.  In some cases, the yield is higher–but that’s not necessarily a good thing (more about this in my next post).  In addition, many well-known large-cap leading lights, like WMT (2.0%), XOM (2.2%), INTC (3.1%) and MSFT (1.7%) have respectable dividend yields.

Individuals are still mostly oblivious…

I don’t see overwhelming evidence that individual investors have picked up on the attractiveness of dividend-paying stocks yet.  They see their investment issue, but not the solution.  In fact, I pointed out in a post in late February that some basic dividend-related investment concepts, like yield support (the idea that at some point high dividend yields would stop stocks from falling further), seemed to have faded from the market’s memory.

..but maybe not for long

That inattention may not last long.  It seems to me that financially and operationally sound companies have begun to signal their health by raising their dividends.  XOM and WMT did so near the bottom of the market.  INTC has just followed suit.  MSFT, which has shown a pattern of raising its payout in December, may be the next market titan to follow.  WYNN (which I own), a much smaller firm, has just made a very strong statement about its financial health by declaring a $4 a share (about 6%) special dividend to be paid next month, plus the initiation of a regular 20¢/quarter dividend.  Of course, part of the WYNN statement comes from the fact that its bankers have allowed the payouts to happen.  Sooner or later, the market is bound to notice.

In fact, Wall Street may already be taking heed.  Another, more subtle, indicator of the market’s attitude toward dividends is to examine what happens on the day a stock begins to trade ex dividend, i.e. the first day when buyers are not entitled to receive an upcoming payment.   Does the stock in question decline by the amount of the dividend, or more?  That’s bad.  Or does it “carry” some or all of the payout, i.e. not decline at all or decline by less than the dividend.  Tis is typically a strong sign of approval.

WYNN is a case in point.  It paid out $4 a share, but declined by $1.52 in a more or less flat market.  So it “carried” $2.48.  I interpret this as meaning that investors are not as unaware of dividend events as they were in February.  (Now, it may be that investors missed the fact of the payout completely, thought the bottom had dropped out of the stock at the open and stepped in to grab a “bargain.”  That would mean the stock’s rise would be a sign of ignorance, not approval.   Maybe so, but I’ve always found it a dangerous to underestimate the collective intelligence of the market.  Yes, LVS and MGM rose, too, but their financial conditions are so more precarious that I’m not sure they’re comparable.)

Naturally, the earlier we are in recognizing a trend toward buying dividend-paying stocks, the better it is for us–as long as somebody else follows.

That’s it for today.  In my next post, I’ll write about how companies decide on a dividend increase–because you want steady and rising income, and where to look for assurance the dividend is secure.

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