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.



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.

large one-time dividends in 2012: why they drive stock prices up

big payouts

A significant number of publicly traded companies in the US are declaring large special (i.e., one-time) dividends to be paid before yearend.  In every instance I’ve seen–the latest being LVS and COST–the stock has gone up significantly on the announcement the company is taking this action.

two tax reasons

There are two reasons for this, the first of which relates to the current income tax preference for dividend income (a maximum 15% federal tax rate) versus “ordinary” or “earned” income (a maximum of around 40%).  They are:

1.  The reasonable supposition that the income tax on dividends will go up in January, either as part of a political deal to avoid the “fiscal cliff” or in a subsequent, more general reform of the tax code whose provisions are made retroactive to January 1st.

A dollar in dividend income today nets the taxable recipient $.85.  In January, it may only have an after-tax value of $.40.

Let’s say, to make the numbers easy, a stock is trading at $100 a share.  It has $8 a share in excess cash.  It has no sure-fire investment projects that have the potential to make large future gains, so that $8 will remain $8 in present-value terms.  For a taxable investor, that $8 a share inside the company is worth $4.80 if it will be paid out after December 31st.

If, however, the entire $8 is paid out in 2012, it is worth $6.80 after-tax–a $2 difference.  So the taxable investor is $2 better off because of the dividend payment.

That’s not the whole story, either.

2.  When this stock goes ex-dividend, its price will presumably drop by about $8, simply because the ex-dividend buyer isn’t entitled to the $8 dividend.   In a very simple world, the $100 price falls to $92.

For the taxable investor who buys the stock for $100 right after the dividend announcement, the fact of going ex-dividend “manufactures” a short-term tax loss of $8.  This loss can be used to shield  otherwise taxable income at the holder’s highest marginal tax bracket.

If that rate is 40%, then the tax loss is worth $3.20.  (For what it’s worth, the part of T. Boone Pickens’ reputation that doesn’t come from relentless self-promotion is based on creating dividend situations like this on a massive scale.  There was also a one time a type of investment vehicle, called a dividend capture fund, whose main purpose was to capture the tax benefits of dividend-paying stocks going ex. )

#1 and #2 together make $5.20.  So the declaration of the $8 dividend has made the stock 5%+ more valuable to taxable investors than before.  In theory, the stock should rise on the dividend announcement until that “extra” value disappears.  That’s also what’s actually happening.

Of course, to use the short-term loss the holder has to sell the stock, creating downward pressure on the price once it goes ex-dividend. But at the same time, non-taxable investors, for whom there are no tax benefits, may be attracted to the issue and lend support because of the substantially lower price.

worth looking for?

For highly specialized professionals, yes.  For the rest of us, no.  One of the first lessons I learned as a portfolio manager is that you should focus all your time trying to find the 30% gains, and the 50%s and the 100%s.  If you see a 5% on the ground in front of you, pick it up.  Otherwise, the gain is too small to spend time on.

So, while it’s nice to understand why a stock is going up, these aren’t worth chasing.  Nor, in my view, is searching for stocks where a large potential special dividend payment is the major attraction worth the time and effort.