Wednesday, February 8, 2012

Dividends Matter--For More Than Just Current Income

For some time, I have thought that a lasting investment theme will be to focus on dividends by owning shares in some of the world's leading companies that pay high and growing dividends.  The demographics of aging societies in the developed world, combined with historic low levels of interest rates on savings and government bonds, should provide strong demand  for the shares of such companies.

But there is another reason to focus on dividends--what a company's dividend actions indicate about the company's long-term prospects.  With dividend payout ratios at historically low levels in recent years, many companies favored share buybacks over large dividend increases.  This was seen as a way for company managements to avoid being criticized for overpaying for corporate acquisitions, which commonly happens when companies are flush with cash.  By announcing large share buybacks, the positive news effect and actual purchases of stock are expected to drive up the share price (and increase the bonus of many executives).  

It even became popular among some prominent Wall Street firms to add a stock's dividend yield to the percent of a company's stock that is repurchased in a buyback program to produce a "total yield" that is much higher than just the dividend yield.  I think, however, that only the cash dividend received by shareholders is the true "yield."  All else equal, a company's purchases of its own shares will add demand and help support the share price, but I have not seen empirical, quantifiable, support for this that would support counting the "buyback yield" as equal to the "dividend yield." 

Unlike a stock buyback, which is temporary, an increase in a company's dividend is a tangible reflection of the confidence that the company's management has in its future prospects.  Companies generally dislike cutting dividends (which is very unpopular with shareholders).  So a company typically doesn't raise its dividend unless management thinks the higher dividend level can be supported well into the future.

A recent example flashed a compelling buy signal based on the above rationale.  Seagate Technology, a leading manufacturer of disk drives), had been paying an annual dividend of $.12 per share.  In late October of last year, the stock was languishing at $12 a share (down from a 2007 high of $29).  Analysts were cautious at best about the company's prospects, as the technology sector has been moving to portable devices such as smart phones and I-pads, instead of personal computers.  But the company then raised the dividend sixfold, to give the stock a prospective dividend yield of 6%.  On that sign of management confidence, the stock spiked.  Management recently raised the dividend another 39% while announcing that quarterly earnings far exceeded analysts' estimates.  The stock is now $26, for a 116% return in roughly three months (plus dividends).

Though this example is extraordinary in the immediacy of the gains to shareholders from large, positive moves concerning a company's dividend, the point is that dividends matter in more ways than one.  And that is something that I think can be counted on in an otherwise uncertain world.

Steve Lehman

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