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A New Day for Dividends?

Jason Stipp

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar.

Investors have undoubtedly shown increased interest in receiving dividends, but are companies showing any increased interest in paying dividends?

Here to offer some insights on the current dividend landscape is Pat Dorsey, president of Sanibel Captiva Investment Advisers.

Thanks for joining me, Pat.

Pat Dorsey: Of course, Jason.

Stipp: You recently wrote a paper titled, "The Turning of the Dividend Tide," and you point out some interesting trends in dividends. But before we get to some of the recent trends, let's talk about the dividend landscape. You say that U.S. companies have been pretty stingy dividend payers. Why is that? What are some data behind that?

Dorsey: The payout ratio, or the percentage of earnings paid out as a dividend, has been declining almost monotonically since the '40s or '50s. It was as high as 50% in the late '80s or early '90s; it's now down below 40%. And this is very much a U.S. phenomenon. You look outside of the U.S., in Australia, in many European countries, dividend payout ratios have consistently been in the 50%-60% range. So, I think the U.S. does stand out in terms of its lack of desire to return capital to shareholders.

Stipp: So, what are some factors behind that? Why our companies putting their money to use in other ways besides dividends?

Dorsey: Well, I think some of it--and this is a very cynical argument, but I am a cynical guy--has to do with how we compensate executives here in the U.S. We have what we call an option culture here in the U.S. Stock options are used to a greater degree than in many other countries. And if you hold an option, you don't like dividends, because the dividend reduces the price of the stock, which lowers the odds that your option gets above the strike price.

Now of course, if you own restricted stock, you love dividends, because you get paid. So, I think that options culture is some of it.

And the other thing, I think, is the truly egregious pay packages we hand out to CEOs here, because bigger companies have CEOs that get paid more. Basically, CEO pay increases with size, not with profitability. And so the rewards for just getting bigger, reinvesting your capital, making dumb acquisitions, pursuing dubious internal projects--the reward for doing that is greater in the U.S. than in many other countries.

Stipp: You also mentioned that there is kind of a perception, perhaps, among management about what it means when you start to pay a dividend. What it says about the kind of company you run? How has that held back dividend payments?

Dorsey: Well, I think especially in the tech sector it has held things back, because … companies seem to sometimes view paying dividends as an admission of defeat: "We've hit middle age. We can't grow anymore. Oh my gosh, our price/earnings ratio is going to go into the toilet."

When in reality, paying a dividend is a declaration of victory. It means that we are so profitable, so successful, we don't need all this cash--hey shareholder, have some back.

And I think that's especially the case in the tech sector, which is a relatively young sector of the economy and has historically been a much faster-growing one, but now just like any part of the economy, it's maturing, and so you are seeing CEOs in that sector having to go through a mid-life crisis of sorts.

Stipp: So, you argue here that there is a turning of the dividend tide, and so perhaps some of this realization by tech sector managers that their companies are a different kind of company than that go-go growth could be one factor.

What are some things that are causing more dividends potentially to be paid out in the future? How do you see that tide turning?

Dorsey: It's a good question, and I probably should have put a question mark after turning of the dividend tide, because I don't know that the fat lady has quite sung yet. But we've had Intel that's had a pretty good dividend policy for several years now. Cisco with that massive dividend increase they had recently. Apple is paying not a large, but at least a meaningful dividend at this point, and Apple is hardly a mature company--at least not yet.

And so I think really what it is, is a realization that first of all, the companies just don't need all that cash. And importantly, I think there has been a little bit of foment among shareholders, especially I think about Cisco, where the company's poor capital allocation was a real beef among the shareholder base, in addition to several other mess-ups by Mr. Chambers. And when the company announced that 75% hike of the dividend a couple of months ago, you saw the stock respond very positively. The market didn't say, "Oh my gosh! You're admitting defeat! you are no longer going to grow!" The market said, "You, sir, are acting your age and we like that."

Stipp: So, companies are perhaps growing up a little bit here.

What about the headwind of the potential tax code uncertainty and the [concern that] taxes on dividends could go up. I think there is fear that this could lead to companies doing more buybacks or something like that, because they don't want to have shareholders saddled with these higher tax rates that they have to pay. Is that going to hold back dividends?

Dorsey: I don't think so, because after the rate was cut to 15%, you didn't just see this giant wave of dividend increases. You didn't see the payout ratio increased massively. A hike in the dividend tax rate seems reasonably likely coming up, and if that were the case, why would Cisco be hiking its dividend tremendously?

Overall, S&P dividends look like they are going to be up, I think, in the high teens this year, in terms of aggregate payout of 2012 versus 2011. Why would CEOs be doing this if they were incredibly freaked out about the tax hike coming up?

Stipp: So investors are looking for dividends. We might be seeing more dividends from companies. What's the smart way to go about investing in this hopefully bigger pool of dividends that we may see in the future?

Dorsey: I think the single biggest theme, really, is to basically not think of instant gratification. Current yield tends to be overvalued. Future growth and income tends to be undervalued in the market, I think. So you see businesses with 5% yields growing at a couple of percentage points--utilities anybody?--trading at very high valuations, and yet you see businesses with 3%-4% dividends growing at very high clips, relatively less rich in the market.

So, I think, the real thing here is focus on the company's commitment to the dividend, it's future growth rate. It requires a little bit of work. It's not as simple as just running a screen, but that's how you get paid.

Stipp: OK. Pat, it's always great to hear from you, especially so when you have some possible good news for dividend investors. Thanks for joining me today.

Dorsey: Thanks, Jason.

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