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The Low-Payers Club

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Cisco announced last week that it was going to begin paying a dividend, somewhat surprising news for a lot of market watchers.

Here with me to talk about who else could be or maybe should be paying a dividend is Morningstar's Josh Peters, editor of Morningstar DividendInvestor and an equity strategist with Morningstar.

Thanks for joining me Josh.

Josh Peters: Good to be here, Jason.

Stipp: So last week, I had Pat Dorsey sitting here and he said, in response to the Cisco news that he could give John Chambers a big kiss, a big smooch, because he thought this was good news coming out of a tech company finally saying it could pay a dividend.

What's your response to the Cisco dividend?

Peters: One-handed applause. I mean literally, that's a line I used in my weekly communication with DividendInvestor subscribers. Just to say, the move was shocking. Came out of the blue, I think that John Chambers had made some reference that before he retired perhaps he'd like the company to start paying a dividend. But this really kind of came out of nowhere.

But to me, I look at it, and I say, 1% to 2% yield, and you're throwing out all of these qualifiers about tax policy determining how much you're going to pay your shareholders. The gap between what they could be doing and what they're actually doing is actually bigger in my opinion than the move that they are actually making.

Stipp: So, certainly we have seen some money piling up on corporate balance sheets. So, in the tech industry it is one thing, but also just broadly, it seems like companies are in better financial shape than they had been before. Do you think that we'll see a trend of more companies potentially starting to pay out, even if it's a little bit, starting to pay out a dividend?

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Peters: Well, it seems like this is a question that comes up every couple of years. I mean, having come through such a traumatic period, so many companies cutting their dividends in 2008, 2009. Hoping for some kind of a recovery this year, but we haven't really seen much of it. I don't know if it's the fact that the economic outlook is still very unclear; tax policy, obviously, there is still some open questions on that front, and only a few months left here in 2010 before, hopefully, we'll have some answers.

But we haven't seen any kind of rush of companies to start initiating dividends or substantially changing their dividend policies in favor of greater cash payouts. There are a few names; Cisco is one, Starbucks is another. Time Warner Cable, actually a company that I like quite a bit, put a fairly large dividend in place right off the bat. These are encouraging signs, but they don't add up to any kind of a landslide.

Stipp: So, I asked you a little bit about this before, and you brought me a list of companies that either are paying no dividend in the S&P or very low yields. And I just wanted to walk through some of the names, some folks that maybe could be, why they are not, or if they even should be. I think there are some interesting ones on here.

So on the no dividend payers right now, the first one I just wanted to touch on briefly is Berkshire. This is a company I think that's widely held especially by a lot of our readers. What's the story behind that? Do you think that Berkshire should pay a dividend?

Peters: Well, my attitude is actually that every company if it is earning an adequate profit and that profit is available to be distributed to shareholders while still providing for the growth and maintenance of the enterprise, then they should be paying a dividend to shareholders, end of story.

Every rule I suppose has its exceptions, and in this case, Berkshire is the exception that literally proves the rule.

The way I look at it is that most companies are only good at a couple of things, a couple of specific activities, lines of business. And if they're capable of throwing off cash that can't be reinvested in that business, it's imperative, really, that that money go back to the shareholders, so that the shareholder can reallocate that capital elsewhere within the industry, elsewhere within the economy, and it's really the shareholder's right, I think, to have the ability to allocate that capital, whether they want to spend it or reinvest it.

In this one rare, rare, rare case, you have a company guided by Warren Buffett, greatest investor of all time. I think we can certainly say that. That there is a very good probability he can actually allocate that capital better than the vast majority of his shareholders.

And one way to look at it this, you know, Warren Buffett may not pay a dividend out of Berkshire Hathaway, but the man definitely believes in dividends.

Look at the companies, the publicly held companies that are part of the Berkshire portfolio, lots of dividends in there. Johnson & Johnson, a name that he has been buying recently, a name I also like that's paying out a yield in the mid- to high 3% range. And this is the kind of stock you can buy and expect literally a bond-like return in terms of the income and the growth in capital gains of a stock.

And then also think about all the operating businesses inside of Berkshire Hathaway, you know a company that become part of the Berkshire story decades ago, like See's Candies.

You know almost all of the earnings of that business have been paid as dividends up to Berkshire as the parent company. You don't think that's See's is sitting on a billion dollars of accumulated earnings anywhere. You know that's not how it works.

So, that is really how the capital allocation comes into the story. In this one case, he can do it, probably better than his shareholders, but I'd say in almost any other case that I can think of, shareholder dividends are really a necessary priority on the part of management.

Stipp: Well, I know I certainly wouldn't want to bet against Warren. But speaking of some of those other companies that are on the list here, there is a lot of tech companies and you think of tech, you know they start out, they need to make a lot of investment, they need to keep coming out with new products. But we have some pretty mature tech companies on the no-payers to the low-payers, including an Apple, a Google, an IBM.

Could Cisco maybe set a tone for these companies? Could some of them really be paying a better dividend, and would you be interested in buying them if they were?

Peters: Well, that's an interesting question, which I suppose is a way of having a delayed answer as I think about it. I mean, you go back to 2003. Microsoft--the giant of all technology, I think as far a user of computers, anyway, sees it--institutes a dividend for the first time actually paid out a fairly large special dividend while inaugurating regular quarterly dividends back then.

Did it set the tone for the sector? Well, Apple wasn't paying a dividend; it hasn't started since. The same thing with Cisco; they waited another seven years before announcing any kind of plans. Google, I mean, wasn't even a public company back then. So, you know, Microsoft really didn't manage to set the tone for the industry, and there may be people who are looking at Cisco inside Silicon Valley, inside the industry generally or even globally, saying, why are they doing this? Why do they want to be identified with food companies and utilities and boring things like that?

And the great irony, you know, a great tragedy really, is that a company like Apple, a company like Cisco, a company like Google, Microsoft, even Intel--these are companies that can throw off so much free cash flow that even as they are growing much faster than the economy as a whole, they could be paying out yields, 4%, 5% or maybe 6%.

Shareholders could literally be getting the kind of yields you wouldn't expect even on utilities stocks these days, and getting all that additional growth. It's just a big difference in these relatively low capital-intensive business models versus something like a utility that has to plow a tremendous amount of money back into the business just to grow 3%. So, I think, that there's still a lacking of maturity in the technology industry.

It's not exclusive to technology; you see Amgen also on the list in health care. I think, they also kind of think along the lines of, "we're a growth company, we need this money available to invest," but as the money just keeps piling up, and you're generating more cash flow than you are consuming, at some point, you have to start asking those questions about, how do I finally benefit as a shareholder from all this cash flow?

Stipp: So would you, if Apple came out and declared a dividend, and it seemed like the yield was pretty good. Would you think about it? Would you invest in one of those companies, or do you still want to see a record of a commitment to a dividend over time before you'd be comfortable?

Peters: Typically, I'd like to see that longer commitment. I mentioned Time Warner Cable earlier having instituted a dividend. I mean, that was actually one reason that I didn't quite step up to the plate and recommend buying the stock to DividendInvestor subscribers, because I want to see, will they raise it in early 2011? That's great that they started it, but unless I'm going to see some consistent growth atop a good yield, you know, I'm still not going to be all that interested.

I think, a lot of dividend investors tend to be fairly demanding. They want to see those long track records. They want to know that they're getting into an arrangement in a long-term investment that they can live with.

Something like a Cisco, I mean, the fact that they've decided to start paying a dividend hasn't changed my opinion of the business all that much. It's still very different than the types of companies--like utilities, like banks, like real estate investment trusts--that a guy like me is used to looking at. And the yield hasn't gone to the point where I'm going to be willing to spend a lot of time getting comfortable with these new businesses, recognizing that there's still a lot more technological change going on for an Apple or a Google, a Cisco than there is for a General Mills or for a Johnson & Johnson. But you put a 4%-5% yield on the table, you bet I'm going to be interested in doing that homework. We're just not at that point yet.

The one name I would call out--it's being paying dividends for decades--is IBM. Now this is nobody's idea of a fast-growing business, but it generates a tremendous amount of cash flow, trades at a very attractive multiple of earnings and free cash flow, but with a 2% yield on a 20% payout ratio, it's just not working for me. A 4% and 40% combination, I think that's a name that I would be very interested in buying.

Stipp: So some other names that are on this list, one of which that you hold is Wells Fargo, but it's not alone among the lower-yielding ones that you pulled out right now. There are a lot of other financial companies there. Do you think financials are going to ... is this just a short-term, it's a depressed payout right now, and we're going to see a recovery there, or what's the trend in your mind from what we're going to see out of financials in the yields there?

Peters: I think so. I think these are temporary low yielders for the most part. Goldman Sachs is kind of the outlier here; a very, very different type of bank than a Bank of America or a Wells Fargo. Frankly, I'm not even sure what it gets out of being a public company. I don't think the dividend is likely to be a meaningful part of that story going forward, so it's in a separate case.

But Bank of America, Wells Fargo, J P. Morgan--these are companies that paid very good dividends prior to the crash. It's been a traumatic event having to cut their dividends, having to have accepted some level of government support, now additional regulation. But the pieces are finally falling into place here 18 months on, where you can start to say, dividends are starting to become a much bigger part of the picture, I think, in 2011 and beyond.

One was you needed the economy to stabilize. I think we have that. Don't have the recovery we would want, but we have the stability. And as long as the economy is stabilizing, you're not going to see huge inflows of additional bad loans. The old ones are either being repaid or literally written off, but you've got a greater sense of certainty around earnings.

A second piece was financial reform legislation. That's on the books. It's not great for these companies by and large, but now they can at least look at it, and for the most part, most of the factors in play you've got some certainty around that.

And then the third piece was capital standards, which are really set on a global basis by the Bank of International Settlements in Switzerland. We've got those numbers now and we're seeing that the big American banks, the better run big American banks are already meeting the capital standards that are going to be phased in with increases over the next 8 years.

These are companies that unlike some of their European counterparts are in very strong capital positions, generating a lot of earnings, especially in the case of Wells Fargo, they're in the position to start making much larger dividend payments, I think, probably by the first half of next year.

Stipp: So certainly some interesting insights on financials there, a broader question for you to end with. The tax uncertainty that's out there, you mentioned it earlier with Oracle – I'm sorry, with Cisco and their announcement of a dividend. To what extent is this going to affect dividend policy? Is this a big issue in your mind that we have to see what the tax legislation is going to say about dividends, before we can see any kind of movement on payouts?

Peters: Well, I think, it will help to have clarity. It will help for everyone concerned. But what I would say to the CEO of a company or the Director of a company is your job is to pay dividends. If you have the wherewithal, you have the earnings, you have the balance sheet strength, you have the business that can generate a recurring, good stream of profitability, your job is to pay dividends. Your job isn't to try to minimize my taxes.

You want to minimize my taxes just wreck the company and have the stock price go to zero, that's a great way to minimize taxes. I think, the idea is to make money and the most money possible, and then hopefully to pay tax at the lowest rates available.

You got to remember a lot of dividend income goes into tax deferred accounts that don't pay taxes. Except on withdrawals, there's no impact by dividend, tax rates on that. Pension funds, charitable trust, there are a lot of investors that this isn't an issue for, but a lot of them are also craving income. I think, what is more likely to going to come down to is an excuse.

Companies as we can see by the yields and the payout ratios of today, they don't want to pay dividends, taxes is more of an excuse to withhold those funds, use it for acquisitions, to build up the empire, use it to buy back stocks, so you can goose your earnings per share a little bit, maybe make that number or beat that number that you might not otherwise.

I think, it's still a case where we have massive misalignments of incentives. I don't know a very many companies, where management is compensated on the basis of how much did you pay in dividends, or have you raised the dividend lately.

I think, we're going to need to see some changes in incentives in corporate America, before we're going to start to see landmark changes in terms of dividend practices. Tax is one piece of the puzzle, but by no means the only piece.

Stipp: Josh, thanks so much for all your insights on the dividend payers and the dividend could be payers, and thanks for joining me again today.

Peters: Happy to be here.

Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.