Playing the Dividend Market- 19th December 2002

Richard Teitelbaum -

Grand investment trends often start with a bang. The OPEC oil embargo fueled the hydrocarbon run of the 1970s. Reagan-era tax cuts kicked off the 1980s rush to consumer products stocks. The Internet triggered the 1990s tech bubble. But Wall Street's big thinkers are predicting that the next big trend will be driven not by gigabytes or the human genome but by a return to a decidedly undramatic, deliciously old-fashioned notion: that healthy dividends are a sign of superior corporate prospects. Going forward, the theory holds, a growing proportion of returns will come from income rather than from capital gains, and investors will flock to dividend-producing shares. Gail Dudack, chief investment strategist for SunGard Institutional Brokerage, is calling it "the new new thing of the decade."
Dividends the new new thing? The idea seems a mite flaky, especially to skeptics who are likely to respond by asking, "Er ... what dividends?" The percentage of companies in the S&P 500 index paying them fell from 94% in 1980 to 70% at the end of 2001. And payout rates shrank much more. The S&P's yield (annual dividend per share divided by share price) shriveled from more than 6% in the early '80s to a minuscule 1.4% last year.
But that's starting to change. The number of dividend increases is up nearly 20% since spring, despite the falloff in corporate profits. A trickle of mainstream growth companies--FedEx, Maxim Integrated Products, and Outback Steakhouse--have recently initiated quarterly dividends for the first time. And dividend payouts by S&P 500 stocks rose half a percentage point for the first nine months of 2002. That's "the first time," notes Tobias Levkovich, a Salomon Smith Barney strategist, "dividends are rising ahead of earnings coming out of a recession."
Why the shift? For one thing investors--deeply suspicious of management, the earnings guidance it provides, and even reported profits--are demanding cash in hand and discounting promises of future earnings. "They want to see the value," says Yale economist Robert Shiller, author of the 2000 book Irrational Exuberance. "It's a 'show me the money' attitude." So far this year investors--many of them hard-bitten by scandalous losses in their aggressive-growth mutual funds--have poured $3.8 billion into equity-income funds, which focus on yield-bearing shares. That's up from $2.6 billion for all of last year and contrasts with dramatic outflows of $16.7 billion in 2000.
Investors are also attracted by the disciplined management that dividend-paying companies often provide. It's the opposite of the gun-slinging culture of excessive leverage and risk that left so many portfolios in a shambles. "History," says Steve Galbraith, a Morgan Stanley strategist, "suggests dividends can serve as governor on capital profligacy." The need to consistently turn a chunk of their operating profit into cold, hard cash for shareholders means company managers are discouraged from doing things that gobble up greenbacks--even if they might push up earnings in too many steady dividend payers, for instance, going on speculative acquisition sprees. (Debt requires interest payments, which in turn need cash.)
Indeed, some financial pros say that instituting a quarterly payout may be the last, best chance for beleaguered tech companies--a group that has long scorned dividends--to woo back skeptical investors. "The only way Cisco is going to hit $20 a share," says investment strategist Dudack, "is if they start paying a dividend."
Historically, dividends have been a key part of a stock's allure. "Prior to the past several decades earnings forecasts were not nearly so important a factor in assessing the value of corporations," Federal Reserve chairman Alan Greenspan said earlier this year. "Instead investors tended to value stocks on the basis of their dividend yields." Those payouts could be rich. For example, in 1930, amid the darkest days of the Depression, Studebaker and American Locomotive continued paying dividends yielding 14% and 13%, respectively. From 1900 to 2000, 4.1 percentage points of the 6.7% average annual real return on U.S. stocks were derived from dividends, according to recent British research. In 13 of the past 20 decades, Dudack found, investors earned more from reinvested dividends than they did from price appreciation.
Fine, but what about more recent history? Didn't non-dividend payers outperform during the latest bull market? Actually, no. During the upmarkets that occurred from 1970 through 2000, dividend-paying stocks delivered a slightly higher average monthly return than did non-dividend payers (3.83%, vs. 3.79%), according to a recent study by Kathleen Fuller of the University of Michigan and Michael Goldstein of Babson College. During downmarkets over that 30-year period, the dividend payers' advantage was greater still: They delivered a -2.2% return, vs. -3.1% for non-dividend S&P 500 is down 22.1% through early November, its 351 dividend-paying stocks fell just 13.1%; nonpayers, meanwhile, plunged 29.9%.
In the coming year growth prospects for equities are likely to be meager too. Figuring normal earnings growth for large-cap companies of 6%, plus a dividend yield of 1.7%, you'd expect a 7.7% yearly return. But as price/earnings multiples continue to contract to their historical average (yes, they're still high), the growth in share prices will lag. Martin Barnes, managing editor of the Bank Credit Analyst newsletter, says that annual total returns after inflation might average as little as 3% or 4% over the next ten years. So given that some very solid companies are offering steady 2% yields, investors might do better to get half their expected payback through dividends instead of risking the full monty on price appreciation.
If dividends are such a natural bonus for investors, you ask, then why did those quarterly checks begin drying up? Taxes, for starters. Dividends are taxed as ordinary income, at a hefty rate of 38.6% for the wealthiest taxpayers--nearly twice as much as the long-term capital gains rate. But more onerous than that, they're taxed twice: Since dividends are paid from companies' after-tax dollars, they have already been assessed once at the corporate rate. (The Republican victories in the House and Senate have raised the chances that Congress will eliminate this double taxation--though veteran watchers of Capitol Hill say the issue won't be resolved anytime soon.)
Many growth-company execs, however, say the real reason dividends went the way of tail fins has more to do with corporate philosophy than with taxes. The best way to reward shareholders, they say, isn't to give away the cash that fuels their growth engines but rather to invest earnings back into the company through R&D or strategic acquisitions. Even corporate share buybacks--which boost the stock price--are more effective than paying cash dividends, they contend.
For years that argument won. Growth companies exploded. And the amount of money spent on share buybacks rocketed up at an annual rate of 26.1% between 1980 and 2000. Trouble is, those buybacks have since come under massive fire as the salutary effects they were supposed to have on earnings per share were squandered, largely outweighed by share dilution as mountains of executive stock options were exercised.
Okay. So you want to add some income stocks to your portfolio. But not just any dividend payer is a good investment. In fact, many of the most tempting payouts are the riskiest. "You need to understand that high yield is a warning flag," says Jennifer Newell, portfolio manager of the Vanguard Equity Income fund. For example, an early-November jump in the yield of Philip Morris, from 5.5% to 6.4%, reflects worries over soft tobacco sales. (What moves a yield sharply up, after all, is often a share price collapsing.)
That's why you need to look at more than just the dividend yield. As with any stock, you'll want to check the P/E ratio, the growth prospects, and the quality of management. Then look at the payout ratio--the dividend per share divided by earnings per share--and compare it with those of other companies in the same industry. In general, a ratio of less than 50% is more than solid. That provides a margin of safety while leaving the company enough cash to continue to invest in its business.
Next, check the long-term debt-to-equity ratio. The interest on debt service may end up competing for cash with the dividend if the company is struggling under its debt load. Sticking to 80% or less will generally keep you out of trouble. (Companies in some industries, like banking, that use more leverage can shoulder a higher ratio.) Since you'll want income down the road as well, look for evidence that management is committed to raising dividends regularly. That means a consistent track record of dividend increases and an absolute lack of cuts or omissions, unless there is a very good reason for them, such as a major restructuring. Also, check to see whether the stock is currently yielding more than its historical average. When a stock's current yield is, say, 200% of its ten-year average, says Vanguard's Newell, that may well be a buy signal.
We put some of those screens to work, using data provided by Thomson/Baseline, to identify 15 secure dividend payers in the S&P 500 ( see Table: 15 Dividend Players to Consider--and Five to Avoid). At the start we tossed out those stocks with yields below that of the index average (1.7%), with payout ratios greater than 50%, and with debt-to-equity ratios above 100%. We also excised those that had cut or reduced dividends over the past five years. From there we proceeded to more qualitative judgments with the help of several savvy analysts and equity-income-fund managers. We factored in Standard & Poor's credit ratings, the dividend growth rate over the past five years, and projected earnings growth. (We also assembled a table of five stocks whose dividends seem less than secure. For that we followed the opposite approach, looking for things like high payout ratios and worrisome balance sheets.)
The common theme among the stocks that made our list is good companies, bad times. Big Pharma, in particular, has been bedeviled by a medicine-chest-full of trouble. At Eli Lilly, sales of Prozac have evaporated in the face of new generic competition, and the Food and Drug Administration is probing some of its manufacturing practices. The stock is down 26.5% from its 52-week high. But Lilly's 2% yield, well above its ten-year average, signals a buy, says Newell, who has increased Vanguard Equity Income's position in the stock. "This is a premier research company," she says, "and there are promising drugs that won't be ready in the near term but will eventually be approved." Lilly's R&D spending, at 18.4% of revenues over the past five years, is far above the industry average. And the company has a number of potential hits, such as depression fighter Cymbalta, apparently close to winning FDA approval.
Then there's regional Bell SBC Communications, whose number of local phone lines fell by more than 2.5 million over the past 12 months and whose earnings are expected to drop 7.1% next year. Despite that bad news, investors get a 4.4% yield, a result of a string of annual dividend increases since 1984, and analysts expect the stock to rise with a reviving economy. Ronald Sorenson, manager of the Strong Dividend Income fund, credits CEO Ed Whitacre, who has trimmed thousands from the payroll and cut capital expenditures by more than half over the past two years. Sorenson cites SBC's lucrative investment in Telmex as proof that it knows how to spend capital wisely too. That skill should come in handy when bankrupt telecoms begin to unload assets.
With mounting problem loans making headlines, banking is bound to be a sector full of cheap stocks. But it's hard to find one with the pedigree of Bank of New York (BONY). Its main line of business is running back-office processing for other financial institutions. So it's less sensitive to interest rate swings than other banks and, accordingly, has long sold at a steep premium to them. Thanks to some recent loan losses, that premium has begun to evaporate as the stock has tumbled 42% from its 52-week high. The market's reaction, though, looks like an overreaction. And that could mean a buying opportunity. "For these guys," says Thomas Huber, manager of the T. Rowe Price Dividend Growth fund, "it's a question of when, not if, they'll recover." Better still, with the dividend, you can afford to wait a bit. BONY now yields 2.8%, nearly twice its five-year average.
True, none of these companies is promising high-double-digit earnings growth for the next dozen years or telling you the stock will double in market cap by 2005. Rather the one line this group is feeding investors is an old-economy stalwart: "The check's in the mail."
And that's just the point.


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