Sell in May And Go Away . . . . At Your Own Risk

Because stocks have had solid double-digit gains over the last 12 months, we hear many people predicting that they are ready for a fall.  In addition, the "Sell in May and Go Away" crowd is giving us all the statistics of how stocks have fared between May and November historically.

The reasons given for a stock sell off are full of language about momentum, price gains, and too much-too soon. We want to add very quickly that few of the "stocks are too high" crowd today were among the "stocks are too low" crowd  at the market bottom in March of 2009.  Indeed, if you go back to their blogs and read what they were saying around the bottom of the market, you will find many of them were saying "stocks are too high," even then.

In the blizzard of words we see written about the stock market, we seldom see the word valuation.  Valuation, it would seem, has no meaning in a high-octane traders' market, where computers are trading with computers for about 70% of the daily volume.  Individual investors seem to have decided that long-term value investing has gone the way of the Oldsmobile.

Ah, but we beg to differ!   In the long-run, valuation will rule just like it always has.The reason is over the last 80 years, S&P stock prices are highly correlated to both After Tax Profits and Dividends.  The computers and traders will wage their daily battles of betting on zig or zag, but in the long-run, zigs and zags will ultimately be seen as vanity, a chasing after the wind.

From a valuation perspective, stocks are still cheap and could only become expensive if the economy were to fall off a cliff and drag earnings and dividends with it.  The chart below shows index of the S&P 500 (red line) compared to Total U.S. After Tax Profits Index (blue line).  Please note that After Tax Profits reached an all time high in December of 2010 and, based on S&P estimates, will rise by nearly 13% in the second quarter of 2011 versus the same quarter a year ago. Tracking the After Tax Profits Index is our favorite way of measuring earnings, because it measures only earnings that companies actually paid taxes on.  

The graph below vividly shows that while After Tax Profits have reached an all time high, the S&P 500 has not. In fact, the chart suggests that the S&P has a long way to go to reach fair value.

Corroborating the view that stocks are still undervalued is the graph of the S&P 500 Index (red line) compared to Total Corporate Dividends Index (blue line).  Total Corporate Dividends paid is an important indicator of the health of the current turn-around in the stock market, because dividends are paid in cash and not promises.  As the chart shows, dividends took a hit during the sub prime crisis.  Importantly the chart also shows that they have turned higher.  S&P is predicting that dividends will grow nearly 10% on a year over year basis for the first quarter of 2011.  Dividends have not reached a new high, but we believe the old record will be eclipsed over the next 12 months.  This would be good news for continued stock price gains.

These two simple, yet important measures of stock market valuations are still flashing green.  That does not mean that stocks will go straight up from here.  In our judgment, it does mean, however, that saying stocks are too high is nonsense, and "Sell in May and Go Away" is worse.

The Dollar's Slide: Terminal or Temporary?

We’ve had a number of clients write or call us lately concerned about the continuing weakness of the U.S. dollar. (It’s down about 10% since December against a basket of currencies.)  Here’s a representative example of their concerns:

“I feel the weak dollar (and growing weaker) is causing us problems and will cause greater problems if the world loses confidence in the US dollar as the world's monetary standard.  Oil is priced in $'s and the dollar's weakened position is costing US and world consumers.  When will the world say enough is enough and then what happens to the US economy?”

There is and old saying among economists that goes: “The solution to high prices is high prices.”  By this they mean that because of the law of supply and demand, higher prices tend to lead to lower demand.  Eventually, this lower demand will cause the sellers of the products to cut prices in order to regain the lost demand.  In this way, higher prices are self-correcting.

The dynamics of currency exchange rates are similar.  To a great extent, the problems tend to correct themselves over time.  As a quick primer, there are five major dynamics that have the most influence over the value of a country’s currency:

Interest Rates:  Holding everything else constant, higher interest rates for a given country relative to its trading partners would cause its currency to strengthen because the high rates would attract buyers.

Inflation:  Higher inflation in a country relative to its trading partners normally weakens its currency.

Balance of Trade: Shifts in a country’s balance of trade exert pressure on its currency.  Growing exports relative to imports strengthen its currency; weakening exports do just the opposite.

Budget Deficits:  Higher budget deficits as a percent of GDP weaken a country’s currency, while lower budget deficits strengthen its currency.

GDP: So long as a country’s inflation rate is muted, the higher the country’s GDP, the stronger will be its currency.

As with most aspects of investing, the expectations of how each of the above factors will behave in the future have as much impact on the value of the currency as their current levels.

This analysis, unfortunately, may produce as many questions as it answers, but such is the nature of discussing currencies.  Someone once said, “When it comes to currencies, everything affects everything.” Having said this, currency fluctuations are a daily concern for us because we own so many foreign based stocks.  Thus, based on our current holdings, we are keeping an eye on the Canadian dollar, the British pound, the Chinese yuan, the Swiss Franc, the Danish krone, and the euro.

Using the above five factors, let us offer a brief analysis of the most likely trend of the U.S. dollar over the next few years. 

• Short-term interest rates in the U.S. are among the lowest in the world.   However, when the current round of quantitative easing (QE2) ends in June, those rates should rise, at least a little.  Further, the Fed is expected to begin raising the Federal Funds Rate (FFR) – now at 0.0% - 0.25% by year end.  So, both ending QE2 and raising the FFR should lift the US$.
•  Core inflation in the U.S. is hovering around 1%, very low compared to our trading partners.  Thus, this is favorable for the dollar.  However, if inflation gets too high, the Fed will raise interest rates to fight it.  (Higher interest rates = stronger currency, part of that self-limiting mentioned above.)
• A cheap dollar makes U.S.-manufactured goods more competitive overseas, helping to boost U.S. exports.  Higher exports improve our balance of trade and GDP and should give a lift to the dollar.  This is a prime example of the self-correcting qualities of a weak dollar.  Ironically, however, a weak dollar means that the cost of imports rise, especially oil.  This puts upward pressure on inflation.  Are you getting the picture of the concept of “everything affects everything?"
• Budget deficits and high U.S. debt relative to GDP are the big killers right now for the value of the dollar.  Standard and Poors’ (S&P), in its recent change of outlook for US debt from stable to negative, said one of the reasons for the action was their belief that prospects for meaningful deficit reduction in the current political climate were low.  As you remember, the Dow Jones fell over 200 points for the day on that news, and S&P’s action jumped from the financial pages to the dinner table.  In doing so, S&P may have done us all a favor by turning up the heat on Washington to make progress on budget cutting.  S&P’s message was clear: clean up your financial house or face a downgrade of your bonds.  Downgrade or no, deficits will continue to play a role in the direction of the dollar.
• The United States GDP is the largest in the world, so that helps.   But it is not growing as fast as GDP in the developing countries of China, India, Brazil and other Asian countries.  Indeed, U.S. GDP is growing more slowly than the global average right now, which has somewhat of a weakening influence on the dollar. 

So there you have it. Combining all these factors and comparing them with similar data from our major trading partner nations is producing a negative demand for the US dollar against most other major currencies.

We believe the two primary drivers of the weak dollar are the negative attitudes by some about QE2 and the size and growth rate of the US budget deficit.  As you know, we have been in favor of QE2 because we believe it has provided needed stimulus for the economy and consumer confidence.  We also believe the Federal Reserve has the will and the power to terminate it without disrupting the markets.  Our view has been validated by the rising stock prices over the last six months; unfortunately our optimism has not been shared by the currency traders.  With QE2 coming to an end, it would seem some pressure on the dollar should abate.  

The problem with the budget deficit is too big to solve in the near term.  Indeed, it is exacerbated by the political divide in Washington.  Yet, the problem is too big to ignore any longer.

As we have evaluated the issues surrounding the weakness in the U.S. dollar, in many cases, we believe they are self-limiting or self-correcting.  However, as we said earlier, the biggest problem facing the dollar is the lack of confidence in Washington’s willingness to make the tough decisions to limit the growth of the U.S. debt.  In light of this, pressure on the dollar may continue.

This discussion of the dollar is not simply an answer to a client question.  We deal with currency decisions everyday.  Four years ago we concluded that the dollar was likely to trend lower.  That was even before, the huge increase in government debt.  We redirected our portfolios to benefit from a falling dollar.  At present, more than 60% of the revenues of the companies we own comes from outside the US. Not only are our companies more competitive as a result of the lower dollar, but when their foreign profits are converted back into dollars, they are higher than if they had been produced in the U.S.  Additionally, nearly 20% of our portfolio companies are domiciled outside the US.  With these companies we are benefiting not only from their growing earnings and dividends, but also from the currency translations.  As an example, one of our biggest holdings is Nestle (NSRGY).  A few years ago Nestle’s stock price in Switzerland ended the year flat.  Taking into consideration the currency translations from the falling dollar versus the Swiss franc, NSRGY made a total return of nearly 11%.

Next time we’ll take a swing at the U.S. dollar’s declining importance as the reserve currency of choice.

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.

So Far Municipal Finances Are Not As Bad As Feared

Analyst Meredith Whitney in December sent the municipal bond world into a hissy fit when she predicted that hundreds of billions of dollars of municipal bonds would default over the next year.  Early on we joined countless municipal experts in disagreeing with Ms. Whitney's prediction.

Governments of all stripes are groaning under their debt loads.  Unfortunately, some politicians seem less intent on balancing their budgets than saving the out-sized fringe benefits of government workers. Yet in spite of some cases of politics a usual, and . . . unusual as in the states of  Wisconsin and Indiana, where runaway legislators shut down the legislative process, progress is being made in almost all corners of the United States in getting costs in line with revenues.

In recent weeks many municipalities across the country have released their 2010 financial reports.  This gives us the opportunity to take a hard look at how our holdings are faring in these tough times.  Thus far almost all the municipalities we have studied have shown improved financial conditions over a year ago.  We own 574 tax-exempt bond issues so we have a ways to go, but there is another important indicator that gives us confidence that things are on the mend.  Of the 574 issues we own, none were downgraded by Standard and Poors or Moodys in the last six months.  Indeed, the ratings changed on only 12 issues and they all rose by at least one rating level.  With tax revenues ticking higher in most states and cost cutting grudgingly underway, we belive we will see a continuation of more rating hikes than cuts during the rest of the year.

We believe even more strongly than we did in December that Ms. Whitney will be wrong in her prediction of massive defaults among municipal bonds.  We now believe unless there are a few anarchists among the legislators of this country -- people who genuinely want municipalities to default -- that the defaults will be few.   

We'll keep you posted as we continue to study our holdings.

Blessings


We own lots of municipal bonds.

Big Dumb Trends: Oil and Gas Are Even More Important After Japan

There are times when the questions seem to be wielding bazookas and the answers butter knives.  In these times we have found that the most profitable action we can make is to focus on what we can know, not dwell on the myriad of issues that no one appears to know.  You may have heard us refer to this as  identifying the Big Dumb Trends.

Earlier this week we emailed to our clients a multiple page analysis of our how we believe the unfolding events in Japan would impact the worldwide economy. (You may request a copy of that document by calling Carol @ 812-421-3203.)  In short, in looking at many major disasters over the last 20 years, we cannot find lasting economic effects from such disasters. In short the devastation is counterbalanced by the rebuilding process.  The cost of human suffering is high and gut wrenching, but the economies of the afflicted region and the world have not been materially affected, as long as adequate capital was available for the rebuilding.  Based on what we know today, we believe this will be the case in Japan.

Please forgive us if we sound insensitive.  You know us well enough to understand that that is not our intention.  Our goal in this blog is to refocus our attention away from the carnage that has befallen our friends in Japan and view a world that is inhabited by 6 billion people and a world that will go on.

Then what is the single most obvious "answer" for the future that we can glean from the disaster in Japan.  We believe that answer is obvious and it is the definition of a Big Dumb Trend.  Nuclear energy as an alternative to  fossil based energy will likely go into a long period of under utilization.  Couple that with the unrest in oil-rich North Africa and the Middle East and you come to one conclusion:  Oil prices are not coming down anytime soon, and will probably trend higher once the economies of the world move to a higher growth rate.  Alternative energy will continue to draw lots of talk and lots of dollars, but the questions these technologies offer have been muted by just as many questions.

Oil and gas will continue to play an out-sized role in the energy needs of the whole world.  If that is the case, what is the best way to play energy?  Buying oil and gas stocks is an easy answer, and we believe will be profitable.  But in zeroing in on  the best idea we have at this point, we arrive at the oil field services companies.

They will benefit in two ways. 1) There will be more highly technical-deep drilling (expensive), 2) There will be tremendous retro-drilling in former productive fields in areas that were thought to be tapped out.  New technologies are showing good results in this retro-drilling field.

Simplifying our idea even further, we believe the best company for the future we see unfolding is Schlumberger LTD. (SLB).

Our reason is simple.  SLB is the largest oil-field services company in the world and possesses a unique position in the industry.  They have what we call the "Goldman Sachs" advantage; that is, they get invited to bid in every major drilling activity.  They don't win every contract, but they see them all and if you get invited to the table often enough, you can pick and choose the ones you want to gear up for.  SLB has done that for years, and we believe, they will continue to do so to their shareholders benefit.

Our Dividend Valuation Model says SLB is about 20+% undervalued.  As you know our valuation model identifies how the market has priced SLB's dividend growth over the years.  Right now, even in the face of all the uncertainties related to energy, our model says the company is undervalued and we have been buying it.  SLB has raised its dividend over 10% per annum over the past decade.  Last year it raised its dividend by nearly 19%.  We predict dividend increases in the 12%-14% over the next 3-5 years.

We'll have more to say on the energy situation and opportunities both obvious and not so obvious in future blogs. 

With regard to the Japanese people and the people in the region, we lift up our prayers to God for mercy and resolution of the current travail. 

We own Schlumberger LTD.

Oil Prices: Ouch or Oh No!

As I sat in his chair my barber-economist stated emphatically that, "Four bucks a gallon gasoline will send the economy back into recession."  I told him that he seemed pretty sure about his prediction, and I wondered what he was basing it on.  He said it was simple; in 2008 the economy was humming along and when a gallon of gasoline pushed toward four bucks, the economy just fell apart.

As he began snipping away at the few locks of hair that I still have, he asked, almost as an afterthought, "What do you think?"  My barber is a good guy and he can carry on a conversation on just about any subject with anybody, and I could tell that the hottest topic in the barbershop in recent weeks had been the skyrocketing price of oil. It was also clear that the consensus of my barber and his patrons was that another recession loomed.

As I began to answer, I thought about the proper degree of diplomacy one should display in disagreeing with a man who is both bigger than I am and armed with scissors and a straight edge.  Thus, I began philosophically, which is always a good way to disagree with someone and yet, blame it on someone else.  I answered, "Mark Twain once said that history does not repeat itself, but it rhymes."

Because I did not understand what Mr. Twain was saying the first half dozen times I heard his aphorism, I quickly interpreted.  "Consumers and businesses can adapt to about anything that they have seen before and can quantify."  I continued on for a few minutes by explaining that I had just read an article in the New York Times about how people and businesses were becoming more efficient in their automobile use. Whereas, prior to the rise in gasoline prices a person might do some form of shopping everyday, they were now working more from a shopping list and making fewer trips.  Thus, the total dollars of their purchases was about the same, but the money they were spending on gasoline was lower

He wondered about all the people, such as himself, who did not have a choice in the matter because they had to drive to work everyday.  I said the article explained that even everyday drivers were conserving by minimizing impulse driving on the weekends.

He is not only an economist-barber, but also a fast barber, as well, and he finished my haircut without much further discussion about oil or the economy. I was sitting in my car with my hand on the ignition when an awkward thought crossed my mind: What if he's right and I am wrong?

It may surprise you to know that I think that thought a lot.  I seldom have any serious doubts about the strategies we employ in managing portfolios.  We are conservative and we pay close attention to our valuation models, so we have far fewer sleepless nights than, say, a hedge fund manager or an aggressive growth manager.  Having said that, we still have to take sides on lots of macro-economic issues and the biggest issue we have to deal with today is the rise in oil prices.

As I drove out of the barbershop parking lot, I began an exercise I must have done a thousand times:  computing how much the average family pays for gasoline in a year. If the average family drives about 20,000 miles per year and their automobiles get about 20 miles to the gallon, they will use about 1,000 gallons of gasoline a year. At $3.00 per gallon, the price before the recent run up, they would spend approximately $3,000 per year.  At $4.00 per gallon the average household would spend a thousand dollars more per year.(As I write this, Reuters is reporting that the average family will spend approximately $700 more at current prices.)

We know that the median family income in the US is about $50,000 and in 2010 the savings rate was approximately 6%, or $3,000.  That would mean that there is plenty of room in the average American's budget to pay an additional $1,000, excluding their attempts to economize that the New York Times described.

The problem, of course, is what if consumers decide to maintain their 6% savings rate.  That means they would reduce annual spending on other goods and services by a thousand dollars per family.  History, however, shows us that the savings rate has fallen in almost all of the oil spikes.  Consumers appear to intuitively determine that the oil spike is temporary and they do not dramatically adjust their overall spending.

As I drove down the road, I concluded that neither $100 per barrel oil, nor $4.00 per gallon gasoline would send the economy back into recession. Furthermore, with most measures of the economy pointing firmly in a positive direction, I could not agree with my barber friend, nor those who are predicting an imminent recession.

Driving a little farther, another awkward thought crossed my mind.  If the current regime in Saudi Arabia were toppled and control of their oil fields fell into the hands of radicals, oil prices could go to $200 per barrel and an worldwide economic recession would be much more likely.

When I got back to the office, I did some quick analysis of the relative prosperity of Saudi Arabia versus some of the other embattled African countries.  I found that the average per capita GDP of Saudi Arabia is nearly $30,000 per year.  That is over two times the per capita income of Libya and five times that of Egypt.  There are issues other than income that are causing the revolutions in North Africa, but the average Saudi Arabian is much better off than the citizens of almost any other country in the region.

In addition, Saudi Arabia has formidable military and police forces that are well cared for by the Saudi princes.  It is doubtful that the military would turn on the rulers as they did in Egypt. Indeed, the royal family has it own military.  Finally, the royal family, much to the displeasure of the US and our allies, has funded the Wahhabi Islamic clerics in the country for many years.  Thus, the clerics are not likely to lead a revolt.

Religious tensions do exit between the ruling Sunnis and the minority Shiites Islamic sects. Iran has long been rumored to be trying to incite a Shiite uprising.  Without some complicity by the military or an invasion by Iran it is very doubtful that the Shiites have the critical mass to overthrow the government.

My conclusion is that the royal family in Saudi Arabia will survive and in doing so, should preclude oil prices reaching prices that would produce a worldwide recession.  It is only a guess, but I would say that the odds of the Saud royal family falling are less than one in twenty.

We are in for some very volatile days in the stock market as the serial revolutions unfold in North Africa.  It will take many months for new leadership to form in many of the countries. Also, the civil war in Libya could last longer than most people think.  In the meantime, as long as oil prices don't go up another 50%, I believe worldwide economic growth will continue at near its current pace.

As I said earlier, we have to come down on one side of the impact of higher oil prices or the other.  For the present, after reviewing the available facts, we are taking the optimistic view.  We believe the oil spike is just that, a spike that will later be at partially erased. As events unfold, however, we could change our minds in short order.  If we do, we'll let you know.

If our view of things is correct, any sell off in the market would provide good buying opportunities for many of our current holdings, including some of the purchases we have made in recent weeks.      

Warren Buffett Is Tap Dancing in Omaha Again

CEO Warren Buffett was tap dancing with gusto Saturday as he reported estimate-busting earnings for Berkshire Hathaway (BRK/A).  The results were far above Wall Street estimates and 43% higher than last year.  Importantly book value (net assets per share divided by total shares) exceeded $95,000 for the Class A shares. 

As many of you know, BRK is the only non-dividend paying stock we own in our models (it's in our Capital Builder Model). We have made this dispensation for Mr. Buffett because in studying him over the years we learned of Benjamin Graham, and in getting to know Mr. Graham's theories, we came to know about the dividend meister John Burr Williams.  We have been convinced for years that Mr. Buffett is really a follower of Williams as much as Graham because of the types of companies he has acquired over the last 30 years.

The common denominator of most Buffett acquisitions, especially his publicly traded purchases, is that they have tremendous free cash flows, powerful brands or competitive advantages, and they pay generous and growing dividends.  Thus Mr. Buffett's non-dividend paying company breaks all our rules, but the underlying companies he owns fulfill them.  There is probably a good analogy here, but I can't grasp it at the moment. 

Berkshire's impressive results are good for the company but are also a great leading indicator for the US economy because of the breadth of industries in its portfolio.  Burlington Northern's results (purchased by Berkshire in 2009) were simply outstanding and make its purchase price look cheap.  But then again, hasn't Buffett always had an uncanny ability to buy the cream of the crop on the cheap?  We are convinced that his greatest legacy will be this: His courage to go on shopping sprees when everyone else is convinced that pillows and tin cans are the best place to put money. 

Another reason we have been buyers and holders of Berkshire Hathaway is that in listening to Buffett's annual lectures to the investing public, he has given many clues as to how to value his company.  We are primarily dividend investors because we believe dividend growth is a great indicator of value.  In listening to Buffett some years ago we realized that for Berkshire Hathaway, book value was the key indicator of value.

The chart above in a multiple regression of book value and United States GDP versus the price of BRK/A over the last 15 years.   As you know, the red line is the actual price and the blue bars are the model's predicted prices for each of the last 15 years.  The checkered bar at the far right is the projected value of BRK/A one year from today based on estimates of the model's inputs.

The model shows the the stock is currently modestly undervalued, and significantly undervalued based on next year's estimates.  In particular, the model is suggesting if historical patterns hold true that BRK/A's price will grow about 16% in the coming year.  Remember this is not a guarantee; it is a mathematical guess.  That would put the stock near $150,000 per share a year from now, a big climb from its current value near $128,000.

You'll note that the model's blue bars have given a good account of themselves in estimating BRK/A's value over the years.  In fact the R2 is over .85.  I'll leave it to you to Google R2 if you want an explanation of what it means.

In trying to provide an order of magnitude for how impressive BRK's 2010 earning data are, it would be like Michael Jordan scoring 60 points in his last year of play.  It is remarkable, it is out of the box, it is a testament to the nerdy kid who grew up in Omaha, Nebraska and never left.  

From an investment perspective nobody has ever done it better.  We congratulate you Mr. Buffett and all your employees.

We own Berkshire Hathaway Cl  B.  Please do use this information for investment decisions.  Please consult your investment advisor.

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.