Dividend Trouble

In the third quarter, an unusual situation arose in U.S. financial markets: dividend yield on stocks surpassed the interest rate on the 10-year Treasury bond. While some technical analysts saw this as a strong “buy” signal, and the market did subsequently rally, the real explanation is probably far less favorable for stocks over the long run.

Since early July, financial markets have been characterized by extreme volatility and risk aversion. Fears of a euro-zone break-up and an ensuing banking crisis, as well as forecasts of a possible recession in the United States, triggered a flight to Treasuries. Investors ignored a downgrade of the U.S. sovereign debt rating by Standard & Poor’s and pushed the rate on the long bond to record lows. At one point, the 10-year bond yielded less than 1.75 percent. Meanwhile, a sell-off in stocks boosted dividend yield on the S&P 500 to 2.2 percent. That on the 30 stocks in the Dow Jones Industrial Average was even higher.

Not that these are attractive yields. They remain solidly negative in inflation-adjusted terms. Moreover, even the yields offered by Altria (over 6 percent) and Eli Lilly (over 5 percent) were small consolation for battered investors. 

Pricing Shares

Dividends are fundamental to stock investment. Conceptually, they determine the price of a share, which is defined by economists as the discounted present value of all future dividend flows from owning that stock. This accounts for the difference between the company’s book value and its market capitalization. Since future dividend flows can’t be known for certain, stock prices fluctuate as market participants guess at their values.

But ever since Wall Street began to rally in the early 1980s, initiating a major bull market, actual dividends played only a minor part of the stock-ownership revolution of the past few decades. Some of the most attractive and widely held stocks of the era never paid dividends at all, and some household names still don’t, including Google and Apple.

The traditional explanation for this is that new companies, active in new markets, need to invest and grow their business. Their cash resources should be deployed to gain a competitive advantage, build a brand and increase market share. Accordingly, few of the innovative companies that trade on Nasdaq pay dividends.

On the other hand, companies in mature sectors are supposed to generate steady, predictable profits and reward their shareholders with stable dividends. Shares of blue chips that have consistently paid cash to their shareholders over many years can be valued in relation to bonds, based on their respective yields. Economist Gary Shilling calls such shares “stocks that look like bonds.”

However, the traditional approach to dividend policy has gone out the window in recent decades. Many start-ups have been able to build global brands relatively quickly and acquired extraordinary pricing power even in rapidly changing markets. They are consistently and highly profitable, debt-free and generate a lot of cash. As a result, they are sitting on large holdings of cash. Google, for example, has over $40 billion even after buying Motorola Mobility for $12 billion in August.

Then again, “mature” industries have gone through dramatic technological and competitive changes. The auto industry is a case in point: Ford and GM, which still have solid global market shares and pricing power, had to suspend dividends and GM even sought bankruptcy protection in 2008.

Automotive parts suppliers have had to reinvent themselves as high-tech operations and to invest heavily to maintain sales. Johnson Controls, which makes interiors and batteries for original equipment manufacturers, has become a global leader in the lithium-ion battery technology for electric cars. It is competing with a variety of green-tech start-ups. Yet, it has been paying regular quarterly dividends since 1887 — for nearly a century and a quarter!

Apple, on the other hand, suspended dividends when it ran into trouble in the mid-1990s. Since then it has bounced back and in mid-2011 it even surpassed Exxon Mobil as the world’s largest industrial corporation in terms of market capitalization. Yet, no dividend is in the offing.