Dividend Dopes

Just as there are a lot of geniuses in bull markets, there are a lot of idiots in bear markets. And in both instances, not everyone is equally deserving of the title. Ideas that seem shareholder-friendly and prudent when stock charts are soaring seem shareholder-hostile and reckless when the charts are plunging down. One telling example of this: Companies that spent loads of money paying out dividends and buying back stock seem brilliant in good times and stupid in
bad times.

In the recent bull market, there was a lot of pressure from investors and new incentives (favorable tax treatments for dividends) for companies to pay dividends to long-term shareholders, rather than hoard profits, or use them for acquisitions. And with the climate highly favorable to profits (low interest rates, rampant global growth), CEOs had plenty of cash piling up on their balance sheets. Dividends were a tax-efficient means of rewarding shareholders who stick around (not to mention executives with big stock holdings). Companies also eagerly repurchased shares during the bull market, for two reasons. First, repurchases would compensate for the dilution created when executives and employees exercised stock options. Second, by reducing the number of shares outstanding, repurchases would make profits look more impressive. Professional investors often value shares by looking at their price-to-earnings ratios—i.e., the amount of profits earned per each share outstanding. The lower the better. Reduce the number of shares, and suddenly the p/e ratio falls even if earnings are flat. (One dollar of earnings spread over 10 shares, is 10 cents per share. But $1 of earnings over nine shares is 11.1 cents per share—an 11 percent increase.)

Data provided by Howard Silverblatt at Standard & Poor's show a significant shift in both dividends and buybacks in the years of the Bush boom. Members of the S&P 500 boosted dividend payouts from $141 billion in 2000 to $225 billion in 2006, $247 billion in 2007, and $123.66 billion in the first half of 2008. That's $595 billion from the beginning of 2006 through first half of 2008.

Today, many executives likely wish they could have some of that money back. Think about the number of companies that in recent months have gone bankrupt or are begging the taxpayers for help. Many of these firms that have admitted they're running out of cash were paying out dividends until very recently. AIG, the insurance company that is now a ward of the state, has a long and distinguished dividend history. From the beginning of 2007 through mid-2008, it shelled out about $2.85 billion in dividends on common stock. General Motors, which has a similarly storied dividend history, has paid out 25-cents-per-quarter dividends (adding up to about $844 million) over the last six quarters. In May and June, GM was purportedly healthy enough that it could pay out a dividend. In August, GM was so sick it needed billions in taxpayer money to make it through the winter. Lehman Brothers paid a dividend of 17 cents a share for the quarter that ended Feb. 28; six months later it was toast. In each of these instances, given the magnitude of their problems, slashing the dividend—or eliminating it entirely—might not have made the difference between survival and failure. (AIG has already borrowed nearly $100 billion from the Federal Reserve.) On the other hand, there always comes a point where, depending on your size, the lack of a few hundred million dollars could mean the difference between surviving or dying. In each case, the managers would have been in at least a marginally better position to weather the tsunami if they had more cash.

Many CEOs likewise might regret the aggressive share-repurchase initiatives they embarked upon during the height of the bull market. S&P 500 members splurged on buybacks, boosting the total from $131 billion in 2003 to $589 billion in 2006, $515 billion in 2007, and $202 billion through the first half of 2008. The total from Jan. 1, 2006, through June 30, 2008: $1.3 trillion. Alas, these shares were disproportionately bought high.

When the brilliant hedge-fund manager Edward Lampert melded Sears and Kmart to form Sears Holdings, retail veterans scoffed that he didn't know what he was doing. But until relatively recently, Lampert defied the critics. Lampert, frequently viewed as a proto-Warren Buffett, used the cash thrown off by the stores to make some acquisitions, invest in the stores, and buy back prodigious amounts of shares. As the company notes in its most recent earnings release, in the past three years Sears has bought "approximately 38.7 million of our common shares at a total cost of $4.8 billion," paying an average price of $124 per share. When Sears' stock was bumping along near $190, that seemed like a genius move. But the stock today trades at about $57, and the company has effectively lost about $2.2 billion on that investment. (Here is the five-year chart of Sears Holdings.) Put another way, the amount of cash spent buying back shares is equal to about two-thirds of Sears' current market value. And in today's environment, a few billion in cash could not only prove an excellent buffer, it would give Lampert more freedom to do what he has done in the past—purchase wounded or busted retailers and turn them around.

Both dividends and share buybacks are now in decline. Among the S&P 500, buybacks peaked when the market peaked in the third quarter of 2007, and dividends peaked in the fourth quarter of 2007. On October 3, S&P reported that some 138 publicly held companies slashed their dividends in the third quarter, saving $22.5 billion. Buybacks are drying up, too. The pace in the second quarter of 2008 ($88 billion) was the lowest since the fall of 2005, down by half from the third quarter of 2007.

© 2008