Rising dividends and buybacks

- compiled from information supplied by UBS

1. The Yield Drought

With money market funds and short-term Certificates of Deposit (CDs) yielding less than 1%, yield-hungry investors are crowding into the bond market, despite the high risks posed by giant structural budget deficits. In 2009, bond mutual funds attracted $375 billion. If, as expected, interest rates rise over the next two years, newcomers to the bond market will experience capital losses. Some of them are likely to turn to equities as an attractive source of income, as well as growth. Currently, there are 19 stocks in the Dow Jones Industrial Average with dividend yields of 2.5% or more; their average yield is 3.3%.

2. Back-to-Back Equity Bear Markets

Dividends didn’t matter much in the 1990s, when stock prices rose 16% annually. But the market mishaps of 2000-02 and 2007-09 reminded investors and corporate managers that capital gains are uncertain. Not only are dividends an ongoing source of income; in times of market panic, when investors are questioning either the veracity of financial statements (as in 2002) or the viability of the financial system (as in 2008), dividend cheques in the mail box are a salutary steadying influence. If, as feared, bulging budget deficits lead to PE compression, dividends will be even a more important component of total return in coming years.

Dividend Resurgence

For these two reasons, we are likely to see a “dividend resurgence”. On the one hand, companies will emphasise dividends more than in the past. This has already happened to some degree. Historically, dividends were unfashionable in Silicon Valley, but over the past eight years, several major US tech companies (including Intel, Microsoft, Qualcomm, Oracle, and Broadcom) have instituted meaningful dividends. On the other hand, investors will pay more attention to dividends and buybacks when picking stocks.

Avoid the Yield Trap…

Although every stock is different, stocks with the highest yields often are not the best “yield plays” because:

• The sectors with the highest dividend yields—utilities, telecom, and consumer staples—tend to be defensive sectors that are likely to underperform during a strong cyclical rebound in profits. Furthermore, some of these high-yield sectors have problematic fundamentals. Utilities have high payout ratios and increasing regulatory risk associated with climate change. Telecoms’ growth is slowing as competition heats up in a well-consolidated industry.
• When a stock’s fundamentals deteriorate, dividends lag earnings and stock price because investors spot deteriorating fundamentals long before the board slashes the payout. So high yields are often a sign of high risk, not great opportunity. Consider GE. The stock peaked at 42.2 in the autumn of 2007, and the board raised the dividend 11% in 2008, suggesting the balance sheet was in fine shape. Investors disagreed, driving the shares down 86% to 5.7 by the spring of 2009, when GE slashed its payout 68%.

…buy the “Dividend Fountains” providing income and growth

• “Dividend fountains” that offer investors a meaningful dividend yield but also have rising earnings and dividends are preferred. Many dividend fountains are also shrinking their share count via buybacks, meaning their “true yield” is even higher than their dividend yield. In a few years, such stocks will offer quite a high dividend on the purchase price. If XYZ has a yield of 3% and the payout grows 8% annually, the yield will be 4.4% in five years and 6.4% in 10 years.
• Companies that don’t pay a dividend are favoured if they can grow rapidly by reinvesting in the business. But contrary to conventional financial theory, UBS believe most large, fairly mature growth companies can pay a decent dividend without hurting their EPS growth. Therefore, the dividend payout enhances total return. Strong prima facie support for this view is that a dramatic acceleration of S&P 500 dividend growth after 2002 (from 3.4%, 1995-2000 to 11.5%, 2002-07) did not cause a slowdown in profit growth, which was actually stronger in the latter period.
• In theory, investors should be indifferent between dividends and buybacks. But in the real world, it is better for shareholders if the company pays a meaningful dividend—often in tandem with buybacks—for these reasons:
• Companies invariably do most of their buybacks when profits are strong, excess cash is building on the balance sheet, and the stock price is high. During recessions, when stock prices are low, companies hoard cash and buybacks dry up. Dividends, by contrast, generally continue to be paid during recessions, providing investors with funds to buy stocks when they are cheap.
• The necessity of paying a regular dividend imposes financial discipline on management. There is more pressure to make prudent capital investments and less temptation to make unwise acquisitions. Although certain companies have a real competence in growing via M&A, deals are intrinsically risky because of: 1) asymmetrical information—the seller knows more than the buyer; 2) integration risk; and 3) deals tend to occur at the top of the business cycle and industry cycles.
• As a practical matter, many investors need income, and it is cheaper and easier to receive dividends than to sell shares—particularly because share sales frequently are ill-timed.
• Although buybacks are more tax efficient than dividends, they are also more risky because the investor may never get a capital gain.

Why dividends are better

An ideal “Dividend Fountain” offers a dividend yield of 2.5%+, EPS and DPS of at least 5% annually, and is using excess cash flow (above that needed to fund organic growth and pay the dividend) for buybacks and judicious M&A.

Preferably, the dividend payout ratio on normalised EPS will be below 40% (vs. about 30% for the S&P 500).