dividends in the US (iii): the 1990s

The most important factor in the performance (or lack thereof) of dividend stocks during the 1990s came at the end of the decade, during the Internet mania.

What were called at the time Technology, Media and Telecommunications (TMT) stocks exhibited exceptionally strong performance for several years, despite the fact that prices were wildly high for much of that time and that many newly-minted members of the club had dubious fundamentals.  The fever was fueled by loony research reports by figures like Henry Blodget of Merrill (subsequently banned from the securities business, now writing on finance for Yahoo) and Mary Meeker of Morgan Stanley (now with Kleiner Perkins).  It also featured the takeover of AOL by Time Warner, which must be one of the most calamitous financial combinations of all time.  These outsized gains came at the expense of the rest of the market, particularly value (i.e., low PE, low price/cash flow, low price to assets issues).

So dividend stocks took another beating, a là the late Seventies, setting them up for a strong run of outperformance once the speculative bubble collapsed.

Tomorrow, the present.

dividends in the US (ii): the 1980s

The 1980s were the inverse of the 1970s as far as dividend stocks are concerned.

Dividends were back in!!

Three factors were involved:


Paul Volcker was appointed as chairman of the Federal Reserve in 1979, with a mandate to break the inflationary spiral that was under way in the late 1970s–and which was poisn for dividend stocks.  He did so by raising interest rates sharply, thereby causing a deep recession in 1981-82 that erased the persistent belief that prices would be able to rise in an uncontrolled way.  Disinflation, slow but continuously reduction in the level of inflation, replaced accelerating inflation as the watchword of the 1980s.

As the rate of change in the price level slows, the ability to raise prices by, say 4% – 5% annually (and therefore profits and dividends) becomes progressively more valuable.  So the stocks that exhibit these characteristics become worth more as well.

commodities price declines

To the degree that the price of commodities inputs stabilizes or falls, and a firm is not forced to pass these savings on to customers, profit growth is enhanced further.


Dividend stocks–mature companies with slow-but-steady growth and substantial free cash flow–were crushed in the inflation-fear frenzy that characterized the late 1970s. After the worst of the ensuing 1981-82 downturn, investors began to notice how startlingly cheap stocks sporting, low PEs,  10% dividend yields and offering moderate growth were.  Adding 5% in earnings growth that causes a 5% rise in the stock price to a 10% yield would produce a 15% total return.  That’s without the higher risk attendant on holding a more cyclical name than a public utility or a cereal company.  And it ignores the possibility that the PE might rise.

The success of dividend stocks in the 1980s was not about a change in investor preferences–that would come after the turn of the century.  This was all about valuation + change in the direction of monetary policy.


Tomorrow, the 1990s.



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.



dividend-paying stocks in the US (II)

the income investor’s decision–maximize current income or maximize total return

Suppose an investor can choose between two stocks:

–stock #1 has a current dividend yield of 5%, but no prospects of either earnings or dividend growth

–stock #2 has a current dividend yield of 3%, and will likely grow both earnings and dividends by 10% per year.

Let’s assume that we’re in a world where we can make long-term predictions like this with a very high degree of confidence, and that neither stock has any special risks associated with it.  Yes, these are unrealistic assumptions, but I want to make a point about the expected income stream.

Which do you choose?  In this case, investor preferences are the key.

the income stock

Someone who wants to maximize current income would probably choose the stock with the higher yield.


Figure out how long it will take for stock #2 to grow its dividend until it matches the current yield of #1.  The answer is seven years.  How long will it take for the holder of #2 to receive the same amount of current income as he would by holding #1?  Eleven years.  Eleven years to breakeven by choosing stock #2 is too long to wait, in my view.

the total return stock

Suppose our investor makes his choice today and that each stock is trading at $100 a share.

Over the next seven years, stock #1 will pay out $35 in dividends and #2 will pay out $28.40.  The difference is $6.60.  However, the earnings for company #1 will be the same as they are today, while those of #2 will have doubled.  By year 11, when the cumulative dividend payments of the two will be equal, the earnings of #2 will be almost 3x the starting level.

For the total return of #2 to exceed that of #1, all that’s necessary is that the huge increase in its earnings generate a rise of 6% in its stock price over that of #1.  In the US stock market, if events play out according to our assumptions, that’s as close to a sure thing as ever happens.

That’s not an iron-clad guarantee, however.  Just as important, it’s also not clear when any relative price gains will happen. That’s not such a good thing if you need the money by a certain date.

the point being…

…if you’re interested solely in income, it takes an awfully long time for a fast grower to overcome the influence of the starting point of its higher-yielding rival.

don’t forget about portfolios!

There’s no law that says that anyone has to make the all-or-nothing choice I’ve outlined above.  You could consider buying some of each and hedging your bets.  Of course, any diversification will mean lower current income for a period of time.

back to the real world: today’s dilemma

Stock #1 is a close as you can get in the equity world to a long-term bond.

At some point, not this week, and maybe not for two years, the Fed will determine that the current economic emergency is over and will begin to raise short-term interest rates from today’s zero.  It will have two targets.  One is to make rates positive in real terms (i.e., higher than the inflation rate, which is currently about 2%).  The second, which it wrote about a couple of months ago, is to get them to around 4.5%.  That’s right, 4.5%! 

The effect on the 30-year Treasury, which is currently yielding 2.60%, will be big–and negative.  As yields rise, bond prices adjust by going down.

During past periods of rising rates in the US, stock prices have generally gone sideways or up.  That’s because the signal for the Fed to begin to raise rates is that domestic economic growth is high–and accelerating, which implies accelerating profit growth for publicly traded companies.

So the growing profits of stock #2 give it a chance to avoid going along with Treasuries.  Stock #1 has no such defense.  The only thing it has going for it is a current yield that’s 2x that of the long bond.

I don’t think this is a worry for right now.  But pure income seekers who hold high-yielding stocks are probably in the same boat as holders of government bonds.  So they face the same portfolio rotation issues that bond investors will, when rates eventually begin to rise–or, more likely, somewhat sooner than that, when markets begin to anticipate rate rises.

I think this makes the practical decision between #1-like stocks and the #2s much more complicated now than it would normally be.







dividend-paying stocks in the US (I)


I remember a brokerage house strategist(from Lehman?) making a sales call in 1984 on the money management firm I was working for.  The main point of his presentation was his belief that there was tremendous predictive value in the level of the dividend yield on the S&P 500 index.  According to the strategist, the dividend yield on the S&P rarely fell below 3%.  It never stayed that low.  Therefore, the dividend yield on the index falling below 3% was the strongest possible sell signal that stocks could give.

As it so happened, the yield had just dipped below the fateful 3% line.  So the strategist’s strongly held conviction was that clients should reduce exposure to the stock market, and should rotate any holdings that remained into a very defensive posture.

Three years later, the index had doubled–and the strategist was out of a job.

Where did he go wrong?

Admittedly, hindsight makes it easier to see, but he missed just about all the important economic influences in play during the period.    Specifically:

–the decade of the 1980s saw great structural economic change in the US, including the emergence of women in the workforce, the widespread move of families to the suburbs, the rise of specialty retailing as competition for department stores, and the change from the mainframe to the PC.  Companies were also expanding rapidly abroad.

The result of all this was that most firms were reinvesting all their cash flow into growing their businesses.  They didn’t want to raise dividends.  In some cases, it would have been a condition of getting new bank loans that they not do so.

–the emergence of discount brokers, along with the move to self-directed 401ks and IRAs, made equity investing accessible to young Baby Boomers who were much more interested in making capital gains than earning income.  We didn’t want income.

–interest rates were in the early days of a quarter-century decline.  This secular movement made capital gains easier to achieve, and current income worth less. (Of course, during the accelerating inflation period of the late 1970s, investors of all stripes actively shunned dividend stocks.)

…and now

Other than for a short period in early 2009, when the dividend yield on the S&P reached 4%–and, by the way, gave a strong “buy” signal in doing so–the yield on the index hasn’t spent any significant time above 3% since 1984.

The dividend yield on the S&P is currently about 2.1%.

Economic conditions also changed substantially since that day in 1984.  In particular,

–the dramatic positive effect on the US of the entrance of women into the labor force has passed, as have the boosts caused by changes in retail and the development of the suburbs.  As a result the trend growth rate of the economy has slowed (from 3%+ to maybe 2.5%); consequently, reinvestment demand for corporate cash has waned.

–many of the iconic firms of the Eighties and Nineties have matured (MSFT is the poster child for this phenomenon) and are generating tons of excess cash.

–the Baby Boom is starting to retire and is less interested in investing for capital gains than to receive steady income.

–at the moment, short-term interest rates are at the emergency low rate of essentially zero vs. what the Fed thinks should normally be around 4.5%.  This is to help the economy heal itself of the wounds caused by twelve years of policy blunders in Washington, widespread regulatory failure and fraud perpetrated by major domestic financial companies.  So income investors can’t achieve their goals by buying government bonds or money market funds.

dividend stocks as underperformers

Stocks whose attraction is solely, or mostly, their ability to pay steady or rising dividends to shareholders have been chronic market underperformers throughout the thirty + years I’ve been involved in the stock market.

But changes in investor preferences, combined with the lack of higher-yielding fixed income alternatives and the increasing propensity of publicly traded companies to pay dividends, have caused a mini-renaissance in dividend stocks over the past couple of years.  Yes, dividend stocks have still been underperformers during the market bounceback that began in March 2009.  But not so much recently.  And, as they usually are, dividend stocks had been substantial outperformers during the market decline of 2007-2008.  So the fact that they lagged in the early part of the current cycle is understandable.

where we are today

According to the most recent Factset Dividend Quarterly:

–400 of the S&P 500 constituents are now paying dividends, the highest percentage since before the Internet bubble burst

–growth in dividend payments is outpacing growth in S&P 500 earnings

–the S&P payout ratio (the percentage of after-tax earnings devoted to dividends) remains at 28.0%, about 10% below what has been typical over the past ten years

–the valuation of dividend-paying stocks vs. their non-dividend counterparts appears to be stretched.

The raw data on this last point are stunning.  According to Factset, the PE of dividend-paying stocks is now 244 basis points lower than the PE of non-dividend stocks.  If we take monthly readings of this statistic over the past twenty years, the median discount is 1304 basis points.  So it would appear on the surface that the multiple on dividend stocks has expanded by over a thousand basis points vs. non-dividend stocks.  …uh oh.   …run?!?

That number is misleading, though.  In rough terms, the 1160 point spread would probably be cut in half if we factor out the crazy valuations applied to so-called TMT (tech, media, telecom–mostly non-dividend) stocks during the Internet bubble.  We might clip off another 100 bp or so if we adjusted for the fact that many companies have changed stripes away from non-dividend to dividend payer over the period we are considering.

Even so, there has been a substantial upward readjustment of the relative valuation of dividend-paying stocks in the US market over the past couple of years.

Is there anything left to go for?  or is the dividend stock phenomenon all played out?

That’s my topic for tomorrow.