Dow Jones Reprints: This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit www.djreprints.com
When companies turn stingy with their profits, the result has historically been a period of disappointing profit growth. That's troubling, because stinginess just hit a record high.
Between 1946 and 2001, when U.S. companies had a relatively high "payout ratio" -- the portion of earnings distributed to shareholders as dividends -- earnings growth over the next decade beat inflation by an average of 4.2 percentage points a year, according to a paper published eight years ago in Financial Analysts Journal. But when the payout ratio was low, earnings declined after inflation.
That finding is worth keeping in mind today, because the payout ratio for S&P 500 companies last year hit a historic low of 29 cents in dividends for each dollar of profit, versus a median of 44 cents since 1980. It looks likely to fall even further this year, perhaps to 25 cents per dollar of profit.
Why are companies holding back on cash payments to stockholders? It's not that they lack cash. Nonfinancial companies in the S&P 500 are now sitting on $1.02 trillion, a record.
Three other reasons for the dividend neglect seem more likely. The first two relate to arrogance and the third to pessimism.
First, companies have come to rely on share repurchases as a means to return cash to stockholders. In the 1970s, companies spent 20 times more on dividends than on repurchases, but over the past decade it has been more of an even split. In theory, share repurchases should be as good for shareholders as dividends -- better if we consider that they're not taxed. In practice, however, repurchases often destroy value instead of creating it.
That's because managers are convinced they can successfully time the market, and so repurchase shares sporadically rather than committing to regular amounts as they do with dividends. Any saver making automatic contributions to a mutual fund knows that they buy more shares when prices are low and fewer when they're high, resulting in a low average purchase price. The regularity of dividends puts the same magic to work for investors who reinvest them.
But managers over the past decade have followed a pattern of spending generously on stock when profits are plump, like in 2006 and 2007. Those tend to be the periods when share prices are plump, too. Worse, repurchase spending all but disappears during a downturn, as it did in 2009. Only now that the stock market has roughly doubled since hitting bottom in March 2009 are repurchases returning in earnest.
"Company management are employing a buy high investment technique," wrote Terry Smith, chief executive of U.K. investment firm Fundsmith, in a recent analysis of the dubious value of recent repurchases.
The second reason dividends might be meager is that the same managers who believe they can time the market also believe that they're better stock-pickers than their shareholders. So they spend cash on acquisitions rather than return it to investors. Most of these lose money, too. From 1998 to 2001, a hot period for the stock market, companies destroyed 12 cents of shareholder wealth for each dollar they spent on acquisitions, according to a 2005 study published in the Journal of Finance. During that period, suitors paid top dollar for firms with unclear earning power and only a tangential relation to their core business. Was that $8.5 billion that Microsoft (MSFT) recently paid for Skype, an Internet phone service that's free to all but 6% of its users? Ebay (EBAY) paid $3.1 billion for the same merchandise in 2005, and then sold most of it at a loss after failing to turn it into a money-maker. Perhaps Microsoft's $35 billion in idle cash has something to do with its not dickering over price.
Third, small dividends might simply mean that companies aren't confident about the sustainability of their profits. Dividend cuts are greeted with investor scorn, after all, so managers try to be prudent when committing to higher payments. Earlier this week I wrote that corporate profits have historically declined when their growth has far outpaced that or worker wages. They have done so recently to a remarkable degree. That's one sign that investors should view the profit boom skeptically. That dividends aren't booming, too, is another.
Track your own buys and sells
Even in times of interest rate uncertainty, a certificate of deposit (CD) can still be part of your cash strategy.
When choosing a stock mutual fund, consider performance, manager track record and cost before investing.
Ask the right questions before you hand over your money
Investing for retirement is more complicated than opening an IRA or maxing out your 401(k)
A balanced portfolio can have a bigger impact on long-term performance than individual stock picking
Find solutions to this and many other problems using
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.
Read Full Article »