SB: Monday Morning Musings (MMM): Where Do Dividends Come From?

05:05pm EST 27-Dec-02 Salomon Smith Barney (Tobias M. Levkovich)

Institutional Equity Strategy

Monday Morning Musings (MMM): Where Do Dividends Come From?

December 27, 2002         SUMMARY

* The perception that dividends only are found at

Tobias M. Levkovich       Utilities and REITs is wrong.

* Banks, Capital Goods, Drug and Energy Companies as

well as Diversified Financials provide the most

dividends.

* Large companies also tend to dominate the dividend

flows, despite the absence of payouts from many

large tech companies thus far.

* Small cap stocks may have a slight advantage on a

valuation basis though.

OPINION

When one considers the $154.4 billion of dividends paid out to investors

annually within the S&P 1500 Super Composite (basically the S&P 500 plus the S&P

400 Mid Cap Index and S&P 600 Small Cap Index), there is a tendency to think of

traditional high dividend yielding stocks as the source of most dividend income.

Indeed, over the past four months, we have listened to many investors wonder

aloud if they should be buying utility stocks or real estate investment trusts

in order to take advantage of our positive view on dividends and the likely

reduction in the double taxation of dividends.

Hence, we decided to provide some additional insight to investors as to the

source of the $154.4 billion of dividends by industry group, and the data may

surprise many investors.  Specifically, as can be seen in Figure 1, the largest

contributors to overall S&P 500 dividends are Bank stocks, followed by the

Pharmaceuticals & Biotechnology industry group, which investors should recognize

is only derived from the drug companies since biotech firms do not pay

dividends.  Moreover, the next greatest source of dividends is the Capital Goods

industry group, dominated by General Electric, while the Energy sector (and

group) accounts for 9% of all dividends.  Furthermore, Diversified Financials

and Food, Beverage & Tobacco (mostly Tobacco) vie with Utilities for a fifth

place tie.  Indeed, these seven areas (out of a possible 23 industry groups)

comprise 67% of all the dividends available to investors currently, with the

Financials sector contributing more than a quarter of all dividends.  Thus,

given its strong free cash flow, propensity for dividends and attractive

valuation, we maintain our overweight on financial stocks, with specific

interest in American Express, American International Group, XL Capital, Wells

Fargo, Morgan Stanley and Bank One.

Figure 1: S&P 500 Industry Groups by Dividend Market Share
(n.b. non posso postare le figure, mi spiace)

Source: Standard & Poor and Factset

In addition, the dividend flows are primarily a function of large cap stocks

(those with a market capitalization greater than $7.5 billion), which accounts

for a surprising 81% of all S&P 1500 dividends (Figure 2).  However, we would

add that the mega-cap stocks (companies with a market capitalization in excess

of $50 billion) account for about 41% of all dividends paid and just above 50%

of all the large cap dividends.  Note that many large cap stocks, including

Microsoft, Oracle, Sun Microsystems and Cisco Systems, do not pay any dividends,

but could do so in the future probably even furthering the weight of large cap

stocks within the dividend paying arena.

Figure 2.

Source: Standard & Poor

Moreover, when we break down the data further (Figure 3), we can see that

Utilities tend to dominate the proportion of dividends found in the small cap

and mid cap categories, while providing very little benefit to the large cap

area. But again, the debt burden for Utilities (in the small and mid cap arena)

and Telecom Services (in large caps) probably restrain their ability to grow

dividends quickly going forward.

Figure 3: Dividend Share by Market Cap Breakdown

Source: Standard & Poor and Factset

We would note, however, that there may be some slight advantage for small- and

mid-cap stocks on valuation currently, particularly when one excludes tech

companies from the equation.  Figure 4 provides additional details, showing that

excluding tech sector names, the P/E on companies with a market cap below $7.5

billion is about 260 basis points lower than those with market caps above $7.5

billion on fiscal 2003 consensus estimates, generating a 17% valuation discount

versus more like a 13% discount on 2002 projections.  Hence, one could argue

that there is some modest advantage in buying non-large cap names such as

Lennar, Biovail or Pactiv.

Figure 4.

Source: Factset and SSB Institutional Equity Strategy

Note that small and mid cap stocks trounced big cap names in the early going

during 1990-92 and again from 2000-02 (Figure 5), but some recent backing off

argues for some slight outperformance from here.  However, we would remind

investors that we tend to be very style-agnostic and think that the dividend

issue will have more influence over time.  And, as a reminder once again, we

would stress that dividend "plays" should not be an exercise as to who has a

large payout now or can boast a high yield currently, but rather which companies

generate excess cash flow to continue raising (or in some cases, initiating)

their dividends over the next several years. In this context, both Consumer

Discretionary and Financial sectors should benefit, in our opinion, with select

Technology names also worth considering.

Figure 5.

Source: Factset and Russell & Co.

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