dividends

I’ve posted on the topic of dividends a couple of times before.  This is probably the most complete.

Generally speaking, when a company begins to mature and is generating more cash than it can profitably reinvest in its business, it should return the extra amount to shareholders.  In some cases, obstacles may prevent this:

–shareholders may not want the money (investor preferences can change one way or the other with demographic and economic conditions);

–tax rates on the receipt of dividends may be punishingly high;

–the funds could be stashed away abroad; or

–management may prefer profitless, but ego-flattering, empire-building to doing what’s best for the firm’s owners.

But, generally, companies do pay dividends.  With the Baby Boom generation moving into retirement age, American investors seem to me to be more interested in dividend income than at any time over the past twenty-five years.

share buybacks

(The other main way of “returning” cash to shareholders is through share buybacks.  In most cases, I’m not a fan.  Yes, they may result in less tax being paid, but I think managements mostly use buybacks as a way of stabilizing the share count–that is, disguising the degree to which stock options gradually shift ownership of the firm away from current shareholders and into the hands of management.)

what dividends signal

There are three key features of dividends, and especially of dividend increases, to be aware of in today’s market:

–the dividend is set by the board of directors, in consultation with management–that is, by the people who are usually veteran participants in an industry and who know the detailed inner workings of their firm inside-out.

–a primary goal of the board is to set the dividend at a level that can be sustained indefinitely.  Therefore, dividend increases signal the company’s belief that business is better than it was and that the firm has entered into a permanently higher level of cash generation.

–dividends are paid out of profits, so a dividend increase signals not only higher levels of cash coming in, but also higher profits.

what’s happening with dividends today?

According to Howard Silverblatt of Standard and Poors:

1.  Of the 389 dividend paying members of the S&P 500, 243 had initiated a dividend or raised their payout rate through the end of last month.  That’s 68 more companies (+39%) than this time a year ago.  Only 4 had decreased the dividend.

2.  The net increase in funds committed to be paid out for the index is $28.7 billion through August.  That’s over double the level of a year ago, and 35% higher than full-year 2010.

3.  The total dividend payout in dollars of the S&P this year is almost–but not quite–back to the level of 2007.  The shortfall of about $16 billion is (more than) entirely due to the financial sector, which contributed 29% of total dividends in 2007 vs. 12% this year.  Ex financials, dividends are higher today than before the financial crisis.

4.  The yield on dividend-paying stocks is 2.6%.  That compares with the ten-year Treasury at 1.99% and the thirty-year at 3.3%.

conclusion

Yes, the US economy may have shifted into a lower gear over the first half of 2011.  But the actions of company directors in raising dividends sends a strong signal that corporate profits are in much better shape than media headlines suggest.