why cash dividends?

In its most common form, a dividend is a distribution of a portion of a corporation’s profits to shareholders in cash.

Yesterday, the Financial Times published an article titled “Alarm grows as investors get bulk of listed groups’ profits:  Unusual situation that tends to occur only in periods of widespread economic weakness.”

The thrust of the article is that companies in the large-cap MSCI Global index are now paying out 51% of their profits in dividends.  That’s up from 43% two years ago (when presumably income for everyone not in natural resources was lower).  It’s also higher than the long-run median of 46%.

Suggested but not stated is the idea that these companies are mortgaging their long-term future by skimping on capital investment to satisfy myopic income-oriented investors. The subtitle of the article suggests the high payout ratio may be a harbinger of recession.

Personally, I’m not alarmed.  And I’m not sure the current situation is that unusual.  In fact, my experience is that corporate attitudes toward, and investor preferences about, dividends vary widely over different time periods and in different parts of the world.

That’s what I’ll be writing about over the next few days.

Some preliminaries today:

–dividends are supposed to be paid out of earnings.  If a company has no current or past profits, it can still make a distribution (why it would is a different question–although some fixed income funds do do this). That kind of distribution is called a return of capital.  The main practical difference is that a return of capital isn’t subject to income tax.

–sometimes a stock split is structured as a dividend.  In the US, this typically happens when the split is very small, like 21 for 20, which would be a 5% stock dividend. In most countries, managements doing so as a substitute for a cash dividend and appear to be hoping that shareholders accept this number shuffling instead of money it (a) wants to retain   …or (b) doesn’t have.

–spinoffs of assets are sometimes structured as dividends, as well.

–managements of dividend-paying companies tend to want to at least maintain the current level of recurring dividend payments.  If a company is feeling especially flush in a given year, it may decide to declare an extra one-time dividend payment.  It will label the payment as “special” or “extraordinary,” to make sure shareholders understand this is not a recurring event.

–unlike the case with preferred shares or coupon-bearing debt, management makes no promises to maintain the current level of dividend payments, or even to pay a dividend at all.   Around the world, however, a dividend cut, meaning reduction or elimination of the dividend payout, is regarded as a very bad thing.  It usually provokes a sharp negative reaction in the stock price   …more so outside the US than inside.  That’s because it signals either very poor management planning or a sharp deterioration in a company’s business.  Investors also tend to have very long memories when it comes to dividend reductions.

–in my experience, the best indicator of a possible future dividend cut is that the company has cut the dividend in the past.  The next best is a close analysis of the sources and uses of funds section of the financial statements.


More tomorrow.



pining for inflation to return


Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.


Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

special dividends and (in)efficient markets

As I’ve already blogged about, many US companies are paying large special dividends to shareholders before December 31st. Either that or they’ve accelerated payouts planned for 2013, distributing them this year instead.  The idea is to avoid the presumably much higher taxes the IRS will be levying on dividends next year.  Some companies, like COST, appear even to be borrowing money to fund distributions.

The after-tax value of a dividend payment in 2012 to a taxable shareholder is likely greater than one made in 2013.  In addition, it may be possible to manufacture a tax loss from the transaction as well–something that would add another bit of extra value.  So it’s not surprising that stocks paying special dividends should be strong performers in advance of the day they start trading ex dividend.

I’ve been noticing another feature they seem to have, however, that I hadn’t anticipated.  The stocks appear to be “carrying” a large part–and in one case I’m aware of, all–the special dividend.  Here’s what I mean:

If a company’s stock is trading at $100 a share the day before it goes ex a $10/share dividend, then in a flat market you’d expect the stock to drop to $90 when ex trading commences the next day.  But the current crop of special dividend stocks aren’t acting true to form.  They’re trading at $93 or $95 or higher instead.

What could be causing this behavior?

I haven’t seen any cases where important news breaks on the day the stock goes ex.  The only thing that I can see is that a buyer is no longer entitled to the special dividend.

I have only one explanation, and a semi-crazy one at that.  I’ve concluded that buyers don’t know that the stock has paid out a large dividend.  Buyers think instead that the stock has just made a large downward random fluctuation that makes it an attractive purchase.

I have two thoughts:

–what I’ve just described could never happen in an efficient market, which tells you something about how much attention Wall Street is currently paying to stocks; and

–I wish I’d thought of this possibility before companies started paying special dividends, rather than when they’re finishing up.

looking at corporate cash balances

AAPL as a model global company

Many publicly-traded US companies have huge cash balances relative to their stock market value.  AAPL is a good example.

The company had just short of $120 billion in cash plus marketable securities on its balance sheet as of June 25th.  That’s about 20% of the stock’s total value at last Friday’s close.  Let’s say 80% of that cash is held overseas in countries that levy little or no tax on corporate earnings.

Like many global companies, AAPL’s tax rate–25.3% during the first nine months of its current fiscal year–is substantially below the 35% statutory rate in the US.  (Yes, the US rate is much higher than in the rest of the world.  Yes, a good part of the reason for AAPL’s lower rate is that it earns money abroad that it declares to be permanently invested overseas and therefore doesn’t repatriate to the US.)

analytic issues

Today’s dominant stock market view is that cash is cash, no matter where it’s located, and that earnings are earnings, no matter how lightly they’re taxed.

In contrast, when I began working on Wall Street in 1978, attitudes about recognizing earnings in low-tax areas and about holding cash balances there were far different from what they are today.

Specifically, in those days, investors in the US mentally subtracted from cash balances the home country tax that would be due if the money were to be repatriated and used for shareholder dividends or domestic capital expenditure.

In the UK, brokerage house analysts went further than that.  They did that work for you. Their written recommendations commonly contained, in addition to actually reported earnings, the same numbers “normalized” as if the firm had repatriated all foreign earnings and paid a full tax rate.  Brokers gave their estimates the same dual treatment.

two views:  what’s the difference?


This is pretty straightforward.  For profits on business concluded by a US company in, say, Hong Kong, the corporate tax rate is zero.  If the firm wants to distribute this money as dividends, it first has to be sent to the US, where it is subject to the 35% Federal corporate tax–and possibly to state tax as well.  If this possibility is all an investor is concerned about–cash in his hands rather than in the company’s (a view the dividend discount model explicitly endorses/encourages), then foreign cash balances are worth substantially less than domestic ones.

Figuring out how much less is more difficult,  That’s because a company gets a credit against tax due to Uncle Sam for any tax paid to the foreign country.  To make a stab in the dark, AAPL’s cash pile is probably worth $20 billion less to our totally dividend oriented investor than its balance sheet carrying value.

On the other hand, if you have faith in company management to maximize the value of the corporation, you’re probably willing to believe that holding the cash balances abroad is the best use of the money.  Maybe the funds are being earmarked for reinvestment there, either through purchase of capital equipment or maybe an acquisition.

So you’re less worried about the fact that the money is in a foreign bank.  You’d also think it would be crazy to repatriate the cash, lose a large chunk to taxes, and the ship the funds back out of the US to pay for foreign expansion.

earnings per share

AAPL’s corporate tax rate for the first nine months of 2012 is 25.3%.  If its pretax total were subject to tax at 35%, eps for AAPL would be about 15% lower.

Another way of saying the same thing is that if we adjusted the AAPL PE multiple to reflect a full US corporate tax rate, it would be about two PE points higher.

why write about this?

As I mentioned above, conventional wisdom is that these distinctions don’t matter.  But this is an expression of investor preferences or “taste,” as academics might put it.  And these are subject to change.  After all, these preferences were substantially different a few decades ago.

My reason for writing is that I think preferences are starting to change again.

Maybe it’s the more subdued state of world economic growth.   Maybe it’s the aging of the Baby Boom and that cohort’s increasing interest in dividends.  Maybe I’m just wrong.  But I think that investors are beginning to become more aware of differences in taxation of profits and of the geographical location of corporate cash.


If so, companies sporting low corporate tax rates– predominantly ones with emerging markets exposure, in my view–may be subject to a lot more backing and filling than is commonly thought as the market discounts the possibility that they’re more expensive than they seem.


“the emerging equity gap”: McKinsey on financial markets in 2020 (I)

the McKinsey financial markets report

The McKinsey Global Institute just published a research paper titled: “The emerging equity gap:  Growth and stability in the new investor landscape.”

The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies.  No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.

its conclusion

The study’s conclusion:  by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms.  To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.

If this is correct, companies may:

–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)

–issue equity on less favorable terms to the firms,

–use capital more efficiently, or

–expand more slowly.

I’m going to write about the McKinsey study in two posts.  Today’s will outline the McKinsey argument.  Tomorrow’s will have my thoughts.

the McKinsey argument

1. qualitative

Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.

the developed world


A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging.  This list of median ages (from the CIA) illustrates this point.  Starting with Monaco, the Florida of Europe, median ages by country range as follows:

Monaco     49 years old

Germany     45

Japan     45

Italy     44

Sweden     43

UK     40

Spain     40

US     37

China     36

world median     28

Indonesia     28

India     26

Many African and Middle Eastern countries fall in the late teens or early twenties.

Why is this important?

As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have.   This increasing risk aversion means they are less willing to buy equities.

pension plan shifts intensify this trend

In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees.  They’ve done this by substituting defined contribution pension plans for defined benefit ones  This shift is now under way in Europe.  Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have.  In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.

the emerging world

Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities.  Two reasons McKinsey thinks so:

–most citizens are too poor to want to take the risk of holding equities, and

–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners.  So they’re not places you’d really want to put your money.

2.  quantitative

In the report, McKinsey attempts to estimate, on a country by country basis:

–how much equity money corporations will need through 2020, and

–the amount that investors are likely to allocate to equities over that period.

equity needs

McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.

It assumes that aggregate assets and earnings will grow in line with nominal GDP.  It applies a valuation multiple to them that’s derived from a two-stage present value model.  McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.

investor allocations

This is a complex process that McKinsey only describes in outline, even it the appendix to the report.

Basically, the consulting firm projects, country by country, future disposable income.  It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant.  For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.

the results?

McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020.  However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”

According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans.  Europe will face a funding deficit of $3.1 trillion.

The real potential problem is in emerging markets.  China is in the worst shape, facing a potential financing deficit of $3.2 trillion.  Other emerging markets face a total funding deficit of $7.0 trillion.

That’s it for today.  My thoughts tomorrow.

Dividend Discount Model

The dividend discount model (DDM), a variation on the idea of present value, is one of the older methods for evaluating a stock.  It is sometimes called the Gordon model, after Myron Gordon, an academic who wrote about it in 1959.

The two main ideas behind the DDM are:

1.  a stock is a funny kind of bond and so can be valued more or less the same way one would a bond (an idea that hearkens back to the day when the stock market was the exclusive province of coupon-clipping descendants of industrial tycoons); and

2. by far the most important thing to an investor is the dividends he receives, so they, not the company’s profits, should be what is evaluated. Continue reading