"Don't Dismiss Dividends"

Sydney M. Williams

Thought of the Day

“Don’t Dismiss Dividends”

September 15, 2010

Since the end of August, the S&P 500 has rallied 7.1%, while the yield on the Ten-Year has risen 10.5% from 2.48% to 2.75%, indicating a quick, sharp decline in Treasury prices. Have investors just tired of negligible returns on cash and only modest returns on bonds? It’s too early to say if this is anything more than reflexive action, but it’s possible. Of course the three-week rally has been dramatic, so it may back off some, or at least go into neutral for a time.

A measure often used to determine the value of stocks relative to bonds is the spread between the earnings yield on the S&P 500 and the yield on the Ten-Year Treasury. Using that metric, stocks appear attractive. The spread today is 480 basis points, only slightly lower than it was in mid August when it reached 514 basis points; however, at the end of last year, when the market was trading where it is today, the spread was 160 basis points. The cause for the widening spread was a combination of a rally in Treasuries and an increase in earnings. (For comparison purposes, at the market lows in March 9, 2009 the spread reached 620 basis points.)

Low interest rates have driven corporations to the bond market – sensibly, in my opinion. Yesterday morning Bloomberg had a story that Microsoft may try to sell as much as $6 billion in bonds, allegedly to buy back stock or pay dividends. While they have a lot of cash, much of it is off-shore; so the company would incur a tax liability in repatriating the money to pay dividends or buy back stock. In May 2009, Microsoft raised $3.8 billion, in five, ten and thirty year notes and bonds. Given the current yield on those bonds, one could expect the company today to be able to raise money cheaper by at least 100 basis points – or an annual savings of $60 million, on $6 billion.

It’s understandable why corporations are raising funds in the bond market. What makes less sense is why individuals are buying those bonds so enthusiastically.

While Cisco, yesterday, declared their intention to pay a dividend – a good sign and, hopefully, a precursor of change – the general attitude toward dividends seems one of indifference. Equity is, of course, inherently riskier than debt and dividends can be reduced or eliminated with greater ease than interest payments. And, of course, there is uncertainty as to what the tax rate on dividend income will be in 2011. The Bush tax cuts are scheduled to expire at the end of this year, meaning that the 15% tax rate on dividends will go higher. Thus far no bill has been proposed to address the tax situation by either the President or the Democratic leadership. If nothing happens, taxes on dividends will increase, for those in the highest brackets, to 39%. The uncertainty as to the tax rate, I assume, has led to caution on the part of companies to use some of their large cash hoards to initiate or increase dividends. On the other hand, it is possible we may see some special dividends paid in 2010 to take advantage of the current tax rate. Should Microsoft proceed with their rumored bond offering, a special dividend may be in the offing.

The big advantage of dividends on common stock is that, unlike interest payments or dividends on Preferreds, they can be increased and often are. Dividends and stock performance are related. Standard & Poor estimates that about one third of their Index’s total performance over the past fifty years is due to dividends.

Additionally the Company (S&P) has what they term the S&P “Dividend Aristocrats”. These are companies within the S&P 500 Index that have increased their dividends annually for at least 25 years. These companies should not be confused with the S&P High Yield Dividend Index, which selects the 50 highest dividend yielding stocks from the S&P Composite 1500 that have also followed a policy of annual increases for at least 25 years. The latter includes some smaller companies. Of the former, there are currently 43 names, 8 fewer than a year ago. According to S&P’s data, the “Aristocrats” have outperformed the S&P 500 over the past three, five, ten and fifteen year periods, “while exhibiting a lower standard deviation across all those time periods”, meaning they did better with less volatility. Through Monday, the year-to-date price performance of those 43 stocks is +5.99% versus the Index which is up +0.61%.

Simply being on this list does not assure positive performance. The companies are on the list for only two reasons: 1) they are included in the S&P 500 and 2) they have raised their dividends every year for 25 years. And the list does change. Ten companies were removed in 2009 and two were added. In 2008, 60 companies were on the list, so there are 28% fewer companies listed today than two years ago, a testament to the financial crisis that precipitated the recession.

Investing for dividends is, obviously, not without risk. In 2009, eight hundred public U.S. companies reduced their dividends. The financial crisis, coupled with recession, created cash squeezes (or, at least, the fear of a squeeze) for a number of businesses, especially those in the financial sector. In the past two years, twenty companies have been removed from the list of “Dividend Aristocrats”, thirteen of which were financials, or financial related. (One, Legg Mason, was added and then removed after one year.)

Nevertheless, some factors are aligned that should favor dividend paying stocks going forward. The FINRA-Bloomberg Investment Grade Corporate Bond Index now yields 4.42%, about 140 basis points above the “Dividend Aristocrats”, a modest premium versus a group of stocks that has a long history of rising dividends; inflation, while positive, is modest, at least for now; the earnings yield on stocks is attractive relative to the yield on the Ten-Year Treasury; historically, dividends have contributed substantially to long term gains; corporations have record levels of cash on their balance sheets; and, perhaps most important, we appear to be in the early stages of exiting – not entering – recession.

As we have oft repeated, it is impossible to see into the future. But, in investing, trend following is not usually a rewarding path. Bloomberg recently reported that in the first seven months of this year $185 billion flowed into bond mutual funds, while $33 billion came out of U.S. equity funds. Savvy corporations are taking advantage of those capital inflows by issuing bonds with historically low coupons. In contrast, stocks have been sold down to pay for redemptions. It is a trend unlikely to persist, though there is no knowing when the turn will come. In the meantime, don’t dismiss dividends.