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The Power of Dividends

Over the past six months, I've been struck by the number of companies that have either initiated or increased their dividend. I screened the entire universe of U.S.-traded stocks with a minimum $1 billion market cap, and found more than 300 higher dividends in the latest quarter. Some of the larger names included 3M (NYSE: MMM  ) , Abbott Labs (NYSE: ABT  ) , Citigroup (NYSE: C  ) , Coca-Cola (NYSE: KO  ) , FedEx (NYSE: FDX  ) , General Dynamics (NYSE: GD  ) , and Procter & Gamble (NYSE: PG  ) .

But the company whose new dividend most caught my eye recently was tiny Utah Medical Products (Nasdaq: UTMD  ) . Though far less famous than the above names, Utah Medical holds a place on my own personal "most admired" list for its wonderfully profitable business (40% operating margins) and zealously shareholder-focused management. As but one example, Utah Medical has repurchased about 60% of its outstanding shares since 1992.

It was specifically this avid history of repurchasing shares that made Utah Medical's dividend initiation all the more interesting to me. The $0.15 quarterly dividend equates to a 2.35% yield and represents about 35% of expected 2004 profits, so we're not talking about a token "starter dividend." This was a statement by Utah Medical management that it has few superior alternative uses for its capital, so the best remaining option is to return a sizeable portion of earnings to shareholders. Share buybacks may remain an option for Utah Medical, but probably only on price weakness.

Back in Nov. 2002, my partner Zeke Ashton also wrote about Utah Medical, but as a case study for the power of buybacks. He showed how Utah Medical had delivered years of fabulous market-beating returns not by developing the next miracle medical technology but by simply repurchasing its own shares at attractive prices. The keyword there being attractive, i.e., single-digit multiples to free cash flow.

Utah Medical shares have appreciated 30% since Zeke's article and are up more than 250% over the past three years. So, the stock isn't nearly as cheap as it once was. With 2004 EPS expected around $1.67 per share on a $25.50 stock, and after backing out excess cash of $4.85 per share, we're looking at a P/E of 12.4. That's by no means overvalued, nor is it undervalued considering that profit growth is in the low single digits on flat sales over the past four years.

I applaud Utah Medical management for recognizing that continued share buybacks at current prices wouldn't yield the types of gains as in the past. As a shareholder via Centaur Capital, I much prefer the cash being returned to me so I can deploy it to even better opportunities elsewhere.

But dividends are so much more than money in your pocket. Universally, dividends create certain incentives -- both on the investor and on the management of the paying company -- which I consider of tremendous advantage. Here they are, with my thoughts on each:

1. Dividends penalize share dilution
Few investors recognize what a toll stock options are taking on their annual returns. When a company issues more than 3% of its float each year in the form of options (and for tech companies, that's typical), that adds up to a massive amount of dilution over time. And what does it cost the company? Nothing, unless it pays a regular dividend. Since most companies pay a set amount per share (say, $0.20 per quarter), then with each new share issued, that's an additional hit to the company budget. Naturally, the higher the dividend, the more powerful this incentive against dilution.

2. Dividends promote more stable ownership
For investors, dividends create a very tangible reason for maintaining ownership of a stock, even through periods of time when investors might otherwise choose to sell. That next quarterly dividend inevitably keeps people hanging on, and the aggregate result is a less volatile stock. (No surprise, then, that dividend-paying stocks have proven to offer better risk-adjusted returns over time.)

3. Over time, dividends reduce your risk of loss
One benefit that's probably less considered is the fact that with each dividend you receive, your cost basis is essentially being reduced (that is, practically speaking, not for tax purposes). Thus, with each dividend received, your risk of permanent capital loss is slowly being reduced. If you hold a dividend-paying stock for enough years, your dividends may eventually cover a significant portion of your cost basis. This is especially true for companies that either pay a large dividend or that regularly increase their dividends over time (the latter can frequently be more powerful than the former).

In conclusion, I'm elated to see companies initiating and raising their dividends. If we're in a secular bear market, as suggested by John Mauldin, then those dividends will become all the more crucial in generating positive absolute returns in the years ahead.

Want help finding dividend-paying stocks? Consider Mathew Emmert'sMotley Fool Income Investor.

Guest columnist Matt Richey has been a longtime contributor to The Motley Fool and is a portfolio manager at Centaur Capital Partners L.P., a money management firm based in Dallas, Texas. The Fool has a dividend-loving disclosure policy.

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