Investors want dividends, but U.S. companies are holding too much cash.
Maybe you can't draw blood from a stone, but evidently you can bleed dividends out of a company like Microsoft. When the software giant said it would pay out a whopping $32 billion dividend in 2004, many people saw it as a watershed moment. Not only because it was a former high-flying growth company doing it, and not only because the move suggested dividends were making a comeback, but also because it suggested that giant corporations could hoard their cash no longer. It was, as the movie trailers say, time for payback.
Microsoft not only had bestowed the largest dividend ever to investors, but it had broken a stereotype: that only financial and utility companies are ponying up.
Three years later, however, some think that the dividend comeback has been something of a dud-while the ability to pay dividends has increased along with corporations' cash-choked balance sheets, payout ratios in the S&P 500 have slunk and are projected to be only a little bit more than 31.5% of earnings for 2007. That's paltry compared with the average historical payout, which is 52.7% since 1936, according to Standard & Poor's senior index analyst Howard Silverblatt. Part of this is a hangover from the 1990s, when investors thought money was better left to companies to put to visionary use and focus on growth.
"The big [dividend] payers are still financials and utilities, with financials being the strongest," Silverblatt says. "The lagger is still technology, where only a third of the issuers paid." After a 2003 tax cut on dividends, he says, "There was hope that more companies would pay, especially technology. And initially they did. In 2003 it was Microsoft, and Qualcomm did it in 2004, but then it started drying up. We heard arguments from tech companies that Microsoft paid and what has it done for them?"
Despite a couple of promising years, the level of dividend increases has stalled, says Silverblatt. Back in 1980, 469 companies in the S&P 500 index paid dividends, and that number went downhill until it hit 351 in 2002. Now it's at 388, "which is nice," he says, "but nowhere near 469." And the dividend yield on the index is only 1.93%.
At the expense of dividend increases, he says, companies recently have resorted to their more favored form of investor compensation: stock buybacks, which Silverblatt believes are hindering dividend growth. Buybacks enjoy pride of place for several reasons. They boost the price of stock for the remaining shareholders, and they offer management flexibility, because a buyback can be stopped at any time. Not so with dividends, which, like a plate of victuals fed to stray cats, are hard to stop giving out when investors get used to them.
One of the people who see the dividend picture changing, however, is Lisa Myers, a portfolio manager at Templeton Global Advisors Ltd. in Nassau, Bahamas. When you look at the industry breakdown of big payers in the company's Templeton Income fund, which she co-manages, she says it's highly diversified and reflects much more than just the regular sectors.
"Other than the fact that it's geographically substantially lower in the U.S. and Japan-because of lower dividend yields [in those countries]-our fund looks like a traditional global fund at Templeton would look right now, which are not funds with an income mandate."
Among the other places to hunt for dividend yield are among REITs, energy companies, consumer staples, telecom and pharmaceuticals. But each sector has its own particular reasons.
"Health care is a mixed bag," says Silverblatt. "Only 54.5% of that group pays a dividend; however, they represent 74% of the market value. So the big names [including] Johnson & Johnson, Merck and Pfizer are paying a little over half, but they represent three-quarters of the money."
Energy is another category that pays out a lot, but not as much as it could, especially with the skyrocketing prices of the shares. While the big oil companies generally pay out dividends and appear in many income-seeking portfolios, he says, the dividends have not kept up with share prices and earnings in these days of $3 gallons of gasoline, partially because of the companies' buybacks.
All of the cash on the balance sheets has dividend fans steamed. Many say even Microsoft is paying nowhere near as much as it could. Josh Peters, the editor of Morningstar Dividend Investor, says he finally dropped the stock from one of his model portfolios in late July.
The Hunt Is On
Brad Kinkelaar, managing director at Thornburg Investment Management in Santa Fe, N.M., and co-portfolio manager of the Thornburg Investment Income Builder (TIBAX), says the unwillingness of companies to cough up the cash they've accumulated is largely an American problem. For the kinds of results that his fund is seeking-companies delivering both strong growth and offering income-he often seeks greener pastures outside the U.S.
"For the Thornburg Investment Income Builder, we try to be diversified across sectors and that's difficult to do in the U.S., and to achieve that we have to go overseas," he says. "We can go almost anywhere and find yields that are better than the U.S., with the exception being Japan."
He says that where people in the U.S. think of 3% as an attractive dividend yield, in the U.K. it's almost 4%, in Australia it's 3.8% and in Latin America 3.4%. Even sectors like telecom and technology are paying almost twice as much in dividend yield in other countries, he says.
"It comes down to the fact that [U.S. corporate] management likes to have flexibility on the balance sheet," he says, "And U.S. investors are letting them get away with having too much of a slush fund. And when you have too much money sitting there, you tend to do stupid things."
The Thornburg fund, say its managers, seeks out companies that have both the ability and willingness to pay dividends and the strength to keep doing it. Among its top holdings are Intel, Chevron and General Electric. But Kinkelaar also points to less traditional names, such as Paychex Inc. (PAYX), a software-based company that provides payroll to small services.
"It has a very strong business model in an industry with few competitors, and generates a significant amount of cash flow and earnings growth," says Kinkelaar. "And it's a technology company. We don't get a lot of those in the U.S."
Myers says that the launch of the fund she co-manages as lead equity portfolio manager, the Templeton Income fund (TINCX), launched in July of 2005, was motivated in part by the fact that companies have been generating such an inordinate amount of free cash flow both inside and outside the U.S. She says this is increasingly being given back to shareholders through dividends and buybacks.
One of the surprises, she says, is that the picture of companies is more diversified, and includes areas like pharmaceuticals, health care, publishing and consumer discretionary product manufacturers.
Pharma has been an interesting value play, she says, despite near-term concerns such as the lack of upcoming drugs in the pipeline, the threat from generics and regulatory issues. In the long term, she says, the demographic shifts toward an older population will favor pharmaceuticals, as will the increasing use of drugs for preventative purposes. Thus she has among her top holdings such names as Merck, Pfizer and GlaxoSmithKline.
John Buckingham, CEO and CIO of Al Frank Asset Management in Laguna Beach, Calif., is first and foremost a value manager, and though he doesn't look at dividends first, it is certainly a factor when he considers a company to include in its funds, including the Al Frank Fund and Al Frank Dividend Value portfolios. Many of the small-caps he concentrates on have, for many reasons, also been good dividend payers. Among these are a number of technology companies such as memory-chip maker Dataram Corp. (DRAM) with a yield of 5.9% as of Aug. 1, 2007; Internet marketing company Traffix Inc. (TRFX), with a yield of 5.4%; United Online Inc. (UNTD), an Internet and media services provider, with a yield of 5.8%; and Nam Tai Electronics Inc. (NTE), an electronics manufacturing services company yielding 6.5%.
"In many of the smaller names in tech we do have solid balance sheets loaded with cash that have generated dividend yields," Buckingham says. "There has been a change, where tech companies realize that investors want a tangible return and many have accumulated tremendous cash positions. ... So there is opportunity if you're willing to get beyond some of the major names and I guess do a little more detective work, and be able to stomach volatility that comes with smaller-capitalization companies."
Buckingham also likes names in the oil tanker sector, names like Frontline Ltd., Nordic American Tanker Shipping Ltd., General Maritime Corp. and Tsakos Energy Navigation Ltd. These companies have returned very high yields, which some people might think of as being on the dangerous side, since it's often the case that too high a yield augurs a bad underlying business and leads investors to believe that the company won't be able to sustain its payouts. But the oil tanker companies, says Buckingham, are simply paying out more of their earnings, the way REITs do. Sure, in years with no profits, that means zip.
But for right now, he says, "The tanker business has been so lucrative over the last several years that their dividends have been extremely high. ... I believe earnings will remain strong for these companies and so it's not a red flag that they are paying high yields, whereas it could be in real estate investment trusts."
Though some consider this business too cyclical, and that the profits could eventually be wiped out when it cycles down, Buckingham disagrees, saying that oil demand should continue to be strong as Asian companies modernize and thirst for black gold, and as oil is cannibalized from more remote locations, benefiting those who ship it.
Banks And Beyond
Josh Peters, the editor of Morningstar Dividend Investor and the manager of two Morningstar model portfolios, the Dividend Builder and the Dividend Harvest, says that financial and utilities stocks and REITs are still the main players offering dividends, but he also thinks there is great potential, with the demographic shifts toward more retirees, for more blue chip companies to do the right thing and become more aggressive at giving cash back to their shareholders.
His favorites are banks, including U.S. Bancorp, Bank of America, BB&T and Wells Fargo, which continue to increase their dividend payouts.
"To me, one of the great untold stories for people looking for high yields is on bank stocks," he says. "You've got the top ten banks in terms of market value on average yielding over 4% right now, and that's 50 basis points higher than the average for utilities [as of around June]. That's a combination of factors: Bank stocks have gone nowhere, except this year they've gone down, where utilities are going up and up. The growth rate among bank stocks dividends has been a lot higher, so the numerator has been going up in the dividend yield and the denominator has been going down."
However, beyond the frontier of banks, Peters says he sees companies in different sectors showing both the ability to grow and pay a dividend.
Another sector not considered enough is energy-focused master limited partnerships such as Crosstex Energy LP (XTEX), Kinder Morgan Energy Partners LP (KMP), Buckeye Partners (BPL) and TEPPCO Partners (TPP).
"These are businesses with limited energy price exposure that's based on logistics-transporting energy and distributing," he says. "Kinder Morgan is an outlier. They pump some oil out of the ground. But Buckeye and TEPPCO and Crosstex, they aren't on the hook for final selling prices."
He says that among such companies you find business models similar to utilities, with stable cash flows, conservative balance sheets and highly predictable current payouts.
"The downside," he says, "is that not everybody can own them because of the tax characteristics. Mutual funds can't own them because they can't catch the taxable income that the MLP passes along to investors. So it's a benefit to the ordinary investor because they're not competing with the trillions of dollars of mutual fund companies to own these things."
For Peters, the growth of a company is not constrained by the size of its dividend. In fact, he thinks that's a myth.
"Just because these companies had growth slower than other companies doesn't mean a slower growing company will provide less return to shareholders," he says. "You have to look on a total return basis. You might find a company that pays no dividend by has 10% earnings growth. That's nice. But I can show you a Bank of America or US Bancorp that are all in the 4.5% to 5% yield range and yet remain capable of growing earnings and dividends at 8% over a long time period."
It's Not What You Pay, But How
David Carter of Carter Asset Management in Abilene, Texas, has a particular interest in yield, as he looks for cash to sluice off for his clients, as 65% to 75% of them are in retirement. However, he's somewhat ambivalent about the kinds of sectors and companies paying dividends and more concerned with their capital discipline and whether they are creating wealth.
"At the end of the day, we're looking at who utilizes our capital the best," he says, adding that value investing icon Warren Buffett and his company Berkshire Hathaway don't pay dividends. "Warren Buffett knew that if he kept that money he could create wealth with the earnings from all those companies he owns. But I'll guarantee you one thing, that if he had a bunch of money he was sitting on and he felt he didn't have a place for it within his timeline, he would pay out a dividend so fast it would make your head spin."