Monday, February 21, 2011

An Open Letter to American Corporations About Your Dividend Policies

As major American corporations you employ a multitude of psychological and scientific analytical tools to plumb the hearts and minds of your customers.  In short, your quest is to find out what your customers want and give it to them.  By contrast,  most companies pay very little attention to what their shareholders want, other than price growth. Doing this you falsely assume that your only constituencies are the Wall Street analysts and money gunners who live or die on each quarter's earnings release.  You forget about the millions of individual investors and asset managers who could care less if you beat, meet, or miss your quarterly earnings estimates by a few pennies, yet do care about your dividend payout policies.

Most companies believe dividend investors occupy the fringe of their stakeholders and are not worthy of much attention.  In short, most American corporations care more about what their customers think than what their shareholders think.  In doing so, you miss a wonderful opportunity to attract and retain an incredibly loyal set of shareholders who take a much longer view of their holdings than do the hedge fund or money gunners.

Oddly enough, you will find that if you talked more about your long-term dividend growth goals you would catch the ears of millions of Americans who are trying to figure out where to put their money where it will give them a living income.

Yet quarter after quarter you invite in only the Wall Street crowd for a discussion of what happened in the last 90 days and offer a glimpse of what may be happening in the next 90 days.  I would think these quarterly dog and pony shows for the Wall Street circus crowd would leave you scratching your collective heads as to whether you are running a business for the ages, or a carnival show that will be packing up and heading for the next town at weeks end.  

For many years in this blog, I have been saying that the lack of attention to the income needs of your shareholders was going to change.  I have long believed that the catalyst for a new emphasis on dividends would manifest itself when the baby boomers reached retirement age.  My reasons for saying this are simple.  In retirement people need reliable and growing income, and Wall Street's computerized predictions of how much income a person "ought" to be able to take out of a body of capital just scares the dickens out of most people.  They don't like the idea of trying to live off of the capital appreciation of their assets, when doing so may mean they are selling in down markets. 

Down markets are very tough on retiree's psyche's.  At a minimum, they realize they are selling securities at the wrong time to fund their daily bread, and at the worst they know they may be taking loses to do it. 

Our approach at DCM is to build each client's portfolio, when possible, so that it produces sufficient income for their living expenses.  In this way, even in bear markets, they are never forced to sell securities to fund living expenses.  They just live off of the monthly income their portfolio generates.

Yet, in assembling a portfolio of dividend paying stocks, I am constantly frustrated by companies with very high free cash flows that pay only a modest dividend.  In most cases these are great companies, but they choose to keep the extra cash in the company rather than paying it out to their shareholders.

I would like to remind these companies of some very important demographics:  Seventy-nine million Americans of the baby boomer generation will soon be retiring.  Judging from the the new clients that come to our firm, I would say only a fraction of them are now focused on dividends for their retirement incomes.  As we explain how important rising dividends can be to them in their retirement, we often hear the words:  "This is what I have been looking for.  I can live with this."

From the 1920s through 1993, the average annual dividend payout ratio of the S&P 500 was near 50%.  The concept of Modern Portfolio Theory took over in the 1990s, during which time academia convinced most major American corporations that share buy backs were a more tax efficient means of rewarding shareholders than cash dividends. Corporations liked this idea because it took a lot of pressure off of them by allowing them to keep most of the money they made instead of distributing it to their shareholders as they had for the 70 prior years.  That switch to a share buyback strategy for free cash flow led to dividend payout ratios falling under 30% by 2001.

Dividend payout ratios began to climb again after the Bush dividend tax cuts of 2003 and nudged above 40% in 2006.  The subprime crisis, which had its genesis beginning in the middle of this decade, again took a toll on dividend payout ratios, and as of year end 2010, major American corporations are now paying out only about 29% of earnings.

This week Met Life (MET) CFO,  William Wheeler, said in the Wall Street Journal that his "'bias has changed' to favor an annual dividend over share buybacks as a means of the return of capital to shareholders."   I have read similar statements from Eaton Corporation (ETN) and Parker Hannifin (PH).

We don't think these companies will be the last to come to this conclusion.  There is an income crisis in this country.  Short-term bonds and CDs yield almost nothing and inflation worries pose impediments to higher yielding, longer term bonds.  The time is ripe for companies to begin a persistent and consistent surge to higher dividend payments.  Your balance sheets can handle significantly higher payouts, and the strong free cash flows you are generating would suggest that many companies can afford as much as a 50% dividend payout ratio again.  If that were the case, the average dividend yield of the S&P 500 would be near 3% and growing between 6%-8% a year. 

Listen to the voices of investors who are looking for rising incomes and want to own companies they can count on for the long-term.  Better yet, listen to your own heart.  If a dear friend said they were looking for a great company with a great dividend, how would your stock stack up?  Stop playing the shell game of stock buy backs and whack-a-mole quarterly earnings, and start playing the game where everybody wins:  pay out as much of your free cash flows as you can in dividends.  Seventy-nine million Americans will thank you, as will countless foundations, churches, colleges, and retirement plans.

The author owns Eaton.  He is looking hard at Met Life and Parker Hannifin.