There is more than meets the eye to Cisco's (Nasdaq: CSCO ) decision to start paying a dividend. No, I don't mean the tactic of borrowing with one hand and paying dividends with another. It has to do with the reason Citigroup (NYSE: C ) slashed its quarterly dividend to $0.01 in January of 2009, less than two years after raising it to $0.54. Geez, why bother with the penny when the dividend is being cut by more than 98%?
Yes, they can (own the stock)
When Citigroup eliminated its dividend in 2009, many mutual fund managers and other institutional investors were required to sell the stock. That's because their investment policy only permitted investments in dividend-paying stocks. The mandatory rush for the exits when a dividend is eliminated can really punish a stock's price. In contrast, cutting the dividend to $0.01 may have spooked many investors out of Citigroup stock, but the penny dividend didn't force them to sell. They could even decide to buy more.
Any dividend -- even if it's just $0.01 -- opens up a whole new class of potential buyers for a stock ... and it's not just value investors.
Now they must (own the stock)
For some investors, a dividend is a mandatory rush for the entrance. With the initiation of a dividend, Cisco becomes a must-own stock for dividend-only index funds. These include (but are not limited to) the iShares DJ Select Dividend Index (NYSE: DVY ) , with almost $6 billion in assets, and a slew of WisdomTree ETFs, including the WisdomTree Total Dividend Fund (NYSE: DTD ) , WisdomTree LargeCap Dividend Fund (NYSE: DLN ) , and the WisdomTree Dividend ex-Financials Fund.
Dividend-based funds typically allocate assets in proportion to the size of the dividend, so the 1.4% forward yield on Cisco will create a lot more demand than a much lower yield.
Vive la différence
Will forced buying by index funds make a difference for Cisco stock? As it turns out, index funds are prominent among Cisco shareholders. The three largest holders, which own more than 11% of shares outstanding, are the three big index fund managers: State Street Global (NYSE: STT ) , Vanguard, and Blackrock (NYSE: BLK ) . Turning to mutual funds, four of the top five holders, and six of the top 10, are index funds. (The top five is rounded out with a growth fund. The top 10 includes another growth fund and two value funds.)
Six of the 10 biggest holders of Cisco stock are not deciding to buy it because they like it. They just do what the index tells them to do. Initiating a dividend creates incremental demand among this important group of potential buyers. Economics 101 says more demand with no increase in supply typically drives up prices.
What's more, Cisco -- historically a growth stock -- is looking more like a value stock lately. Although management is targeting growth of 12% to 17% per year over the coming three to five years, investors seem skeptical. They should be. In Cisco's most recent quarter, EPS fell to $0.37 from $0.40 a year earlier. Analysts are forecasting year-over-year EPS declines for the coming two quarters and an EPS decline for fiscal 2011, which ends in August.
It is no wonder growth investors have largely bailed on the stock, which is trading at a paltry 10.4x P/E ratio. That is the kind of multiple that attracts value investors. And value stocks are associated with dividends. Cisco announced it is targeting a dividend yield of 1% to 2%, and its $0.06 quarterly dividend produces a forward yield of 1.4%.
Offering a dividend won't restore impressive EPS growth to Cisco. But the stock could use some buyers, and its recent results won't attract growth investors. Initiating a dividend forces buying by some institutional investors and creates an additional group of potential buyers among institutional investors that are restricted to dividend-paying stocks. It also makes the stock more appealing in general to value investors, a group suitable to the company's recent results. With about three-fourths of Cisco's stock held by institutions and index funds prominent among its top holders, Cisco needs the incremental demand the dividend creates.
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