Monday Morning Musings: Dissecting The Dividend Divide

Analyst: Tobias M. Levkovich

Stock ratings are relative to analyst's industry coverage universe

Institutional Equity Strategy                                                   

Monday Morning Musings: Dissecting The Dividend Divide    

November 15, 2002         SUMMARY                                               

* Dividend payers are outperforming those that do not

Tobias M. Levkovich       pay them                                             

* Corporate America is beginning to recognize this 

trend                                                

* Addressing "double taxation of dividends" could    

further bolster the case                             

                      * Higher stock prices associated with dividends      

lowers the cost of capital of payers vs. non-payers

* Our screen of companies that can either initiate   

             or lift their payouts yields some intriguing names,

including AXP, HD, AIG and MSFT                    

OPINION

All referenced figures can only be seen in the PDF version of this document

available on GEO and FC Linx

In our September 9, 2002, call note "Don't Discount Dividends," we highlighted

the potential for change to the current double taxation of dividends structure

and also pointed out that any adjustment to the tax situation could be quite

beneficial to stocks.  Moreover, we reminded investors that dividends

historically provided nearly half of the equity market's returns over the past

100 years, such that a return to more traditional stock market basics would be a

positive development especially after the aberrational events of the late 1990s,

a period in which valuations soared uncharacteristically, and the early 2000s,

when investors suffered payback for that prior irrational experience.

We think that there is an increasing chance that the issue of double taxation of

dividends may be addressed now that there is a Republican Congress.  We would

also point out that dividends have begun to increase ahead of earnings for the

first time in 30 years (see Figure 1); hence, the market may be indicating that

investors expect change to the legislation as well.  Indeed, it would seem as if

corporate management teams are getting the idea of bumping up dividends as a

means to attract and retain shareholders looking for income as well as

appreciation potential.  Furthermore, it is intriguing to note some companies

have been lifting their payouts of late.  For example, Sallie Mae raised its

dividend by 25% on November 7th, while others like Microsoft felt a need to

defend its decision not to introduce a dividend when they recently reported

their quarter (although we understand that the dividend issue is still under

consideration).

Figure 1:

Source: FactSet and Economy.com

Moreover, dividend-yielding stocks have outperformed their non-dividend

counterparts as can be seen in Figures 2 and 3.  This indicates a shift in that

investors are no longer just purchasing stocks for further appreciation based

solely on future growth expectations, but rather that they want to see some

nearer term benefits via dividend income.  Thus, investors no longer want to

"Wait for Godot."  In our view, the market is beginning to speak and it is up to

investors to pay heed and as observers of the market ourselves, we should be

taking lessons.

Figure 2:

Source:  FactSet and Salomon Smith Barney

Figure 3:

Source:  FactSet and Salomon Smith Barney

As a reminder, the severe drop in the S&P 500 dividend yield (Figure 4) reflects

a conscious decision by companies to rein in dividend increases, opting instead

to buy back stock. This propped up EPS gains (or at least offset dilution from

options issuance), which thereby drove share prices higher, thus allowing

investors to benefit from preferential capital gains tax treatment.  In

addition, one must also recognize that Standard & Poor's has changed the S&P 500

constituents over the years, with a distinct growth bias, reflecting the popular

"zeitgest."  In this context, S&P index decision-makers were willing partners

not only to the tech bubble but also the abandonment of dividends, in our

opinion.

Figure 4:

Source:  FactSet and Salomon Smith Barney

Some have argued that the dividend yield needs to be much higher before stocks

offer investors appropriate returns, but we think one has to compare the

dividend yield to T-bill yields in order to better understand where investors

have come into the market in the past.  Thus, it is not the dividend yield

itself, but its relative level to alternative yields (like those on cash) which

have helped define rally points in the market (Figure 5), not to mention that

the inflation is chipping away at those T-bill returns now.

Figure 5:

Source: Federal Reserve and Salomon Smith Barney

Screening For Opportunity

In this context, we think dividends will grow in terms of investors' preference.

Screens can be useful in uncovering stocks that benefit, especially if there is

movement in Washington to address the double taxation of dividends.  Note that

we do not see this issue as one where ideology separates Republicans and

Democrats, based on our discussions with people in Washington, since both sides

of the aisle seem to agree that some stimulus measures should be done (the issue

is how it gets paid for).  However, we would point out that screens that simply

look for high dividend yields can be highly misleading as often times one simply

discovers those companies with unsustainable dividends.  In this vein, we

screened for companies that have low payout ratios, lots of cash on the balance

sheet reinforced by strong free cash flow and are growing EPS.  Figure 6

provides a list of these companies that are within the S&P 500 and a number of

leading U.S. companies come to the fore including a few on our Recommended List,

such as American Express,  Dell Computer and Home Depot.  Moreover, we have

indicated that we consider Wal-Mart attractive as well.

Figure 6:

Source:  FactSet and Salomon Smith Barney

We should note that the screen also picked up a few names that do not pay

dividends such as AIG, MSFT, CSCO and DELL, which could change if the markets

continue to reward the dividend-payers and thereby lowers their cost of capital.

The argument that "growth" companies need to reinvest all of their cash to

continue growing seems to be falling flat in the current environment (as

measured by stock price performance) and the expectation of continued muddling

economic growth may make it harder to convince investors that using all the cash

for growth is appropriate.  Thus, while we expect some investors to argue

vehemently that growth companies should not pay dividends, they may come out on

the losing side of the argument especially if Washington takes action next year.

The M&A Option

To some degree, there is also an argument that growth could come in the form of

acquisitions despite the fact that many (if not most) deals have not generated

the kind of returns that were expected.  Nonetheless, we must admit to being a

bit encouraged by the very recent acquisition activity.  In the past week, we

have seen HSBC announce its intent to acquire Household International for $14.2

billion, Plug Power buy H-Power, Fiserve's acquisition of an EDS unit for $320

million, Simon Property Group's hostile bid for Taubman, and as mentioned in the

news possible TRW Automotive $4.7 billion sale to Blackstone.  Plus, Corning

sold a lens business to 3M for $850 million.  Thus, things might be getting to

that point where business managers on Main Street see better value than money

managers on Wall Street do.

We do not think that dividends preclude M&A options, especially if stock prices

go up on the news and, thereby, a company's cost of capital is lowered.  These

two issues are not mutually exclusive since many dividend payers do make

acquisitions.

Companies Mentioned

American Express Company (AXP-$36.95; 1M)

American International Group (AIG-$65.75; 1L)

Cisco Systems Inc (CSCO-$14.00; 1H)

Corning Inc. (GLW-$3.37; 1H)

Dell Computer (DELL-$30.94; 1H)

Home Depot, Inc. (HD-$27.84; 1M)

Household International, Inc. (HI-$27.50; 3H)

Microsoft Corporation (MSFT-$56.99; 1H)

Plug Power Inc. (PLUG-$5.40; 1S)

SLM Corporation (SLM-$104.40; 1M)

Simon Property Group (SPG-$33.77; 1H)

Taubman Centers (TCO-$16.99; 1H)

Wal-Mart Stores, Inc. (WMT-$55.57; 1L)

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