The Dividend Question
Investors introduced to stocks in the last half-decade have asked some unusual questions in their quest for financial success – questions like, “What’s the target price?” “Does Henry like it?” and “Will Cisco buy it?” But given the president’s recent proposal to eliminate the tax on dividends, investors may soon be asking the much more sensible question, “What’s the dividend yield?”
A renewed focus on dividends certainly would be a step in the right direction. Thinking more about dividends means thinking more about a company’s long-term earning power and less about “beating expectations.”
There has never been a reason for investors to ignore dividends. Dividends have accounted for more than 40% of the annual return produced by stocks over the 1926-1997 period, according to Jeremy Siegel’s “Stocks for the Long Run.” Dividends were a great help in the bear market years of 1966 to 1979. Stock prices rose just 1.78%, but dividends elevated the total return to 5.8% annually. Dividends shrank in importance during the 1995-2000 bubble period, as rising prices accounted for 19.23% of the 21.31% annual return from the S&P 500.
Ignoring Dividends: A Brief History
Historically, dividends have enjoyed much more attention than they do today. From 1802-1870, for example, Siegel tells us that the total return on stocks hovered at about 7.1%, 6.4% of which was due to dividends. Over the period from 1871 to 1925, the return on stocks remained virtually unchanged, while the dividend component of the return fell to 5.2%. From 1926-1997 period, when the return on stocks shot up to 10.6%, the percentage due to dividends slid further to 4.6%. Today, that figure is lower still: at 1.7%, the dividend yield on the S&P 500 remains near all- time lows.
The renewed focus on dividends is also a reminder that stocks aren’t a compelling value even after falling for three years running. Compare the current 1.7% S&P yield to the 3% that the S&P 500 generally delivered in the ’60s before rising to 5% in the late ’70s. It wasn’t until the ’90s that yields dipped below 3% and stayed there. Bulls have blamed such low yields on the double taxation of dividends, but the president’s proposal to remove the tax would also remove that argument.
Nor can low interest rates explain away today’s historically low yields. The 1.7% yield competes with the 5% yield to maturity on long Treasuries. Yet Treasury yields were lower (around 4.5%) and dividends higher (near 2.6%) near the 1966 stock market peak.
Certainly, eliminating the tax on dividends would be positive for shareholders of dividend-paying companies. Even tech investors have found such a prospect exciting, making the case that more tech companies will set aside cash for distributions. The stock of tech giant Oracle jumped 6% the day the company hinted that it might pay a dividend should the president’s tax proposal become law.
Ignoring Dividends: Hypothetical Yields
The prospect of tech companies paying out dividends presents an opportunity to value these companies as if dividends were paid. Take tech giants Oracle and Microsoft, for instance. Looking at consensus earnings estimates, we can calculate what these stocks’ hypothetical dividend yields would be at, say, a 40% payout schedule – the ratio the S&P generally delivers. For a share of Microsoft, recently priced at $56.28 and expected to earn $2.16 per share in the year ending June 2004, that yield would be 1.54%. Oracle’s case is not much different: priced at $12.99 and expected to earn $0.46 per share in the year ending May 2004, the tech firm’s dividend yield would amount to only 1.42%.
Even at today’s prices and using payout ratios that would make a tech CFO’s head spin, these giant tech stocks still look expensive. Such valuations hardly reflect the much higher dividend yields typically found at bear market bottoms. And remember, these yields are based on earnings estimates more than a year out, which assume a strong recovery in the second half of ’03. This conclusion – that stocks aren’t cheap – confirms a recent Wall Street Journal analysis of the 66 tech stocks in the S&P 500 boasting free cash flow. The Journal calculated that if those stocks paid out half of their cash flow generated over the past year, the group would yield a paltry 0.58%.
Valuation concerns aside, we have some questions of our own about the bullish assumptions surrounding the new dividend talk. First of all, do companies have the wherewithal to deliver a dividend worth waiting for? Given the nature of their business, most tech companies already have enormous demands on their cash flow. Can these companies generate enough cash to invest in plant and equipment while funding research and development, and pay shareholders a distribution as well?
Even if firms decide they can afford to pay worthwhile dividends, it does not necessarily follow that they will. Many companies, tech and non-tech alike, have aggressively bought back stock in recent years. Management has argued that seeking to realize “shareholder value” in this manner makes more sense than paying (or increasing) a dividend. However, much of the stock buyback activity in recent years has been driven by the need to minimize dilution from stock options. Will companies cut back on option excesses enough to affect the payout ratios?
Ignoring Dividends: Understated Payout Ratios
Today, payout ratios generally are at the low end of their historic range. In theory, that means that companies have ample room to ratchet up dividends and increase yields going forward. Certainly we think an investor would be better served with a higher dividend than another debt- financed acquisition or share buyback program. We wonder, however, if the payout ratio isn’t understated given the uncertainty of earnings today. If Standard & Poor’s Core Earnings concept (which results in lower earnings per share than reported) is a more valid indicator of corporate earning power, then the payout ratio is unusually high, not unusually low. Companies may have less discretion on payouts than advertised.
It’s also possible that the new talk about dividends has already been priced into the market. The S&P 500 rallied 2% from the Friday before the president’s announcement of his tax proposal through the following Friday. Utility stocks also gained 2% and REITs, which would lose some pizzazz under the plan, lost 2%. But dividend-paying stocks in general have outperformed handsomely for some time. Dividend payers in the S&P 500 actually gained almost a full percent from 2000 through 2002, while the rest of the index fell 40%. If stocks have already discounted elimination of the tax, we may not see much of a boost even if Bush’s tax proposal is passed.
But this last eventuality is far from a sure thing. Opponents of removing the tax on dividends argue that relatively few investors will benefit from the change. One advocacy group claims that almost 40% of the benefits that would go to elderly investors would flow to those making more than $200,000 a year. Certainly mutual fund shareholders would benefit, but the vast majority of those investors own funds in tax-deferred accounts. Besides, states are unlikely to follow suit by eliminating the dividend tax as a source of revenue. According to the National Governors Association, the lost income related to dividends would amount to 8% of state budget deficits. The point is simply, there are no guarantees that the exemption will become law.
for the Daily Reckoning
January 20, 2003
P.S. In general, however, the renewed focus on dividends is positive. More dividends could mean fewer silly acquisitions, more long-term planning, and fewer self- serving stock buybacks. More emphasis on dividends and earning power might mean less emphasis on creative accounting…after all, there is no such thing as a pro- forma dividend. Unfortunately, stock market valuations based on today’s dividend yields are yet another indication that the broad market has yet to bottom. That means this bear has further to run.
The stock market is a sideshow.
Center stage, gold, the dollar, debt, deflation and central bankers are having a brawl.
“Debt Bomb,” headlines this week’s Barron’s. Instead of cheerleading for Wall Street, the financial press is beginning to ask questions. “Nothing to worry about? Or prelude to disaster?” continues the headline.
We offer an answer: a disaster.
Debt is not necessarily a bad thing; a man who borrows at 5% in order to make an investment that pays 10% is no worse off. But that is not what happened in America’s consumer- capitalist society. Individuals borrowed to increase their consumption. And businesses borrowed in order to finance acquisitions, stock buybacks, and mergers – usually at absurd prices. Corporate chieftains were not interested in the kind of capital investment that might produce real profits over the long term; what they wanted was celebrity status in the press, the kind of flashy results that would impress the lumpeninvestoriat, and a higher stock price so they could cash-out their options.
Deprived of adequate capital investment, business profits have been declining – as a percentage of GDP – since the ’60s, with the most recent cyclical peak in ’97. Imports from overseas have been rising – with the trade gap headed to a new record of 6% of GDP in 2003.
Not that consumption can’t help build a strong economy; American consumers have helped create one of the biggest economic success stories in history – in China!
But now, American individuals and businesses face $31 trillion in debt – with no painless way of paying it.
That is the problem with a consumer economy. Consumers need to be able to pay for what they buy. But as resources are diverted from capital investment to consumption…consumers have less real money to spend.
Of course you’ll recall, dear reader, the remarkable speech by Ben Bernanke on November 21st of last year, in which the Fed governor offered to make our debts a little lighter by inflating the currency and thus cheating the creditors. He told the whole world that the planet’s biggest debtor would make sure the currency in which those debts were calibrated continued to lose value – even if it meant resorting to the ‘printing press.’
Not too surprising, then, that the holders of dollar assets began to look for other places to keep their wealth. Since the day of Bernanke’s speech, the price of gold has risen from $317 to $356. The euro has gone up too, from 99 cents to $1.06. Don’t be surprised to see these trends continue. And now the latest from Eric. It is a holiday on Wall Street today…but Eric is on the job:
Eric Fry, reporting from Wall Street…
– The Dow Jones Industrial Average slid 198 points last week to 8,586, while the Nasdaq tumbled 4.9% to 1,376. The major averages still cling to respectable gains for the year, although the gains are somewhat less respectable than they were one week ago.
– The Dow and the Nasdaq are both still ahead by 3% year- to-date. But the buoyant optimism of the New Year is fading fast. Back on January 1st, most investors embraced the fantasy that stocks would move higher in 2003 because corporate profits would recover, oil prices would moderate, the dollar would regain its footing and the messy little problem over in Iraq would quickly and antiseptically resolve itself.
– But it looks like this dream scenario is running into a hitch or two. Corporate profits, for one thing, are proving to be very disappointing. The fourth quarter earnings results from big guns like Intel, Microsoft and IBM weren’t terrible, but the same cannot be said of their earnings growth prospects. Intel’s CFO Andy Bryant said it best, “I can’t tell you when things will really start to pick up.”
– The news that Intel plans to slash its capital-spending budget for 2003 hammered tech stocks up and down the technology food chain. The Philadelphia semiconductor index lost more than 12% last week.
– While stocks swooned, the dollar suffered another of its periodic fainting spells, falling to nearly $1.07 per euro – its lowest level against the euro since October 1999. Speeding the dollar’s decline was the usual cast of “enablers”: slumping consumer confidence, frightening news out of Iraq and – the coup de grace – a ballooning U.S. trade imbalance.
– The nation’s international deficit in goods and services surged to $40.1 billion in November, from $35.2 billion in October. After a while, all those billions start to add up, and the sum of this equation is a half-trillion-dollar trade annual deficit, which will weigh heavily on the dollar’s value.
– “For several years, King Dollar made for a one-way bet,” writes Doug Noland. “An unending flow of speculative finance into U.S. securities (Recycling Bubble Dollars) for years buoyed the U.S. dollar, despite rampant and eventually self-defeating credit excess and ballooning trade deficits…’Eventually’ has arrived,” Noland proclaims. “The great dollar speculative bubble is in the process of bursting.”
– Bad news for the dollar, however, is good news for gold. Defying the “wisdom” of central bankers worldwide and the confident clairvoyance of Wall Street’s million-dollar strategists, gold’s persistent strength continues. The yellow metal added $1.80 last week to $356.80 an ounce.
– “If this is a recovery,” says Comstock Partners, “it is certainly the most unusual one on record…All of the negative factors we have been discussing in regard to the economy, corporate earnings, excess valuation, investor complacency and a vulnerable stock market are falling into place and are about to become obvious to all…We are getting ever closer to that final capitulation that drags the market down to more reasonable values.”
– Closer, perhaps, but still some distance away…
Back in Paris…
*** Gold stocks fell 3.2% last week.
*** Consumer confidence has fallen again in January; it has fallen in 8 of the last 12 months.
*** Industrial production dropped in 2002 – the first time since ’74-’75 that it has fallen two years in a row.
*** The Financial Times reports that the U.S. economy may have been in recession in the last quarter.
*** “It’s good to see you here,” said Père Marchand before Sunday’s service. “This is unity Sunday, after all.”
Père Marchand knows we are not true French papists. We have been going to the little Catholic church in nearby Lathus for…what, could it be 7 years already?…but we never heard him express an opinion on Episcopalianism…until Sunday.
“This is the day set aside by all churches – Catholic, Protestant, and Orthodox alike – to pray for unity,” Père Marchand began his sermon.
“There is only one true church,” he continued. Then, in his effort to promote religious harmony, the priest described how Episcopalians had gone astray:
“King Henry the 8th of England wanted to divorce his wife, because she had borne him no child. Divorce was something that was not permitted, so he placed his own interests and his own desires ahead of the Christian community…ahead of his duty as a Christian and ahead of the Church itself…and had himself proclaimed as head of the new catholic, with a small c, Church of England…
“And if you think about it, you realize that this was how all these breakaway religions were formed – by people who put their own beliefs and interests ahead of the one true church proclaimed by Jesus Christ….”