December 20, 2005

In the days before the Great Depression and the Securities Exchange Act of 1934, an investor’s primary clue to deciphering a company’s financial well-being was the payment of dividends.  In these modern times, financial data is available 24/7 to anyone with a computer and a modem. Therefore, it becomes vital for investors to sift through the myriad of data to determine what data points will lead them to a successful investment. One approach that has met with success is to build portfolios of high quality companies with at least three common characteristics:  (1) A strong balance sheet with low or declining debt levels, (2) strong and growing profit margins that manifest themselves in the form of rising earnings per share, and (3) positive earnings surprises. Companies that exhibit these characteristics tend to have one common denominator: strong free cash flow. A healthy level of free cash flow provides a company with tremendous financial flexibility. In addition to investing back into its own business, a company could utilize that money to reduce debt, repurchase shares or return the money to its shareholders in the form of dividend payments.

In an environment of low interest rates and expected low financial returns, investors are beginning to place a premium on companies that have the ability to pay and, importantly, regularly increase dividends. The payment of dividends reassures investors that earnings growth is real and that the company currently has, and expects to maintain, the financial strength and flexibility needed to continue to pay those dividends. In fact, paying dividends is one of the easiest ways for companies to convey their financial strength, stability and sentiment about their future profitability. 

Following two years of very strong earnings growth and limited capital investment, U.S. corporations today are flush with cash. It is unlikely that companies will sit on these piles of cash indefinitely. Shareholders are increasingly demanding that cash be put to productive uses or be returned to investors.

Recent changes in taxation of corporate dividends are increasing their attractiveness, not only to investors, who pay tax on dividends at a reduced rate, but also to corporate executives. Restricted stock plans are rapidly replacing option grants as the preferred method of deferred compensation for corporate executives because dividends are not paid to holders of option contracts but are paid to holders of restricted stock. To corporate executives, compensation in the form of dividends taxed at 15% is very attractive compared to ordinary income taxed at up to 35% when an option grant is exercised.  We have also seen an increase in companies paying large “special dividends” that signal a clear indication of management’s willingness to do what is in the best interest of shareholders.  Investors are increasingly catching on to the “bird in the hand” attractiveness of the dividend component of total return during a time of slowing market gains. As can be seen in the chart on the previous page, through November 30 of this year, the S&P 500 stocks that pay dividends have performed better than the non-dividend paying stocks.

The fact that many asset management firms are starting income-oriented funds is further evidence that investors are beginning to value the more secure income component of an investment over the less predictable appreciation component.  Additionally, given the low level of rates within the fixed income market and the aging of the US population, the desire to invest in funds and securities that can provide individuals with higher current income is stronger than ever. 

The above chart traces the level of the S&P 500 Index (red line) from 1950 through today. The blue line maps out the dividend yield on the S&P 500 over the same period. As the markets, and the gains generated through price appreciation, soared through the eighties and nineties, dividends became less and less important to corporate America and the investors who owned their stock. The focus was almost exclusively on earnings growth and the accompanying share price increases. Companies across virtually all industries eschewed dividend increases, or paying dividends at all, to reinvest profits into projects that could maximize earnings.  In fact, it was not until 2004 that dividends began to grow at roughly the same rate as earnings. It is our opinion that for the foreseeable future dividends should grow at a faster rate than earnings and that the dividend payout ratio will increase.

Just as paying or increasing regular dividends can signal a company’s profitability, other dividend-related actions can send negative signals to the market. Cuts in the dividend rate could indicate that difficult times lie ahead or imply that a company may have taken on more debt that it can handle.  A company’s low dividend yield, when compared to its peers, could signal that its growth prospects are already reflected in a fair or overvalued stock price.  A low dividend payout ratio may also signal that management is not confident that cash flow will be sufficient to support a higher dividend longer-term.

Dividend payments are important to investors for a number of reasons. While they generate stable levels of income for investors at attractive tax rates, they can also be important indicators of a company’s overall financial health. We at Westwood have always believed that the ability to generate positive cash flow can give a company the financial strength to see itself, and its investors, through tough times while giving it the ability to outshine its peers in the good times.

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