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Of all the chaos during the fall of 2008, the implosion of the Reserve Primary money market fund may have been the most underappreciated event. The fund "broke the buck," with each $1 invested suddenly worth $0.97. That drop caused a bank run that roiled credit markets until the Fed stepped in to backstop the entire industry.
Breaking the buck in the money market world was akin to failure. People invested in money markets because they wanted the stability of cash with the premium yields of bonds. The industry spent years convincing them this was doable. Once investors learned it wasn't, and that their investments could in fact lose value, they rushed for the doors. Fast.
But as Joe Nocera of The New York Times wrote in 2009, this was hardly a case of reckless management. "When you think about it," he wrote, "the Reserve Fund didn't really 'collapse.' Rather, one of its securities defaulted and it lost a few pennies for its investors. It happens. "
The solution, Nocera writes, is not to increase regulations in an attempt to prevent money market funds from breaking the buck. It's to change investors' mindsets, so that they understand that assets with higher returns come with higher volatility. Money market funds might fall below par from time to time. That's OK. If you need absolute stability, keep cash under your mattress. If you want a higher yield, accept a bumpy ride. End of story.
There's a corollary here with dividend stocks.
For good reason, dividends are the new rage. The holy grail of the dividend world is stability and growth. People don't just want big dividends. The highest honor of a dividend-paying company is the ability to say, "We haven't cut our dividend in 25 years, and have actually raised it every quarter."
But should that be the golden criterion here? Folks, no business is that stable. The soundest company in the world goes through ups and downs. This isn't anything to be ashamed of. It happens, as Nocera might say.
Yet cutting a dividend is considered a desperate move, and it rarely happens. Out of more than 7,000 companies that reported dividend activity, just 145 cut payouts last year. Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) didn't slash dividends until bankruptcy was knocking at the door -- and even then, it was because of a regulatory mandate.
Companies keep their dividends stable over time in one of two ways. In one approach, they pay out a fairly low percentage of earnings, retaining cash when earnings are high to pay dividends when they're low. In another, they raise capital when earnings are low, then use those proceeds solely to pay dividends.
Neither makes good business sense. Anyone who thinks it makes sense for a company to hold cash in the bank today so that it can pay you tomorrow needs a lesson in the time value of money. And the overwhelming majority of the time, when a company raises capital with the express purpose of paying a dividend, the net outcome leaves shareholders worse off.
What if, instead, a business paid out a high percentage of earnings -- say 80%-90% -- and the dividend fluctuated with quarterly results? Earnings are high one quarter, and the dividend is big. Earnings drop the next, and it's smaller. The company loses money in the next, and the dividend stops, brought back only when profitability is regained. This isn't a bold idea. It's how most privately owned businesses operate.
In this scenario, total dividends paid to shareholders would likely be higher, and total returns would also likely rise over time. History makes it clear that companies with the highest total returns emphasize dividends. Part of this owes to the compounding power of reinvested dividends; part is the sad truth that management often squanders whatever extra money it doesn't pay to shareholders.
The one drawback here is that dividends would lose their predictability, fluctuating by quarter. Retirees in particular would stomp their feet. They say they need stable, steady dividends to live off, and they'd actually favor consistency over size.
But this gets back to the problem with Reserve Primary: If investors can't accept volatility, they shouldn't invest in volatile assets. If stability is the goal above all else, invest in cash and bonds. Stocks can provide greater returns, but with them, investors should also face the ups and downs of the business cycle.
One compromise might be to pay small, consistent quarterly dividends, with an annual payout that fluctuates with earnings. Those looking for stability would get their steady quarterly payments, while those who can accept the ups and downs of owning a business could reap the annual payouts, or lack thereof.
At any rate, management shouldn't undercut shareholder returns in an attempt to make stocks more bond-like. Freddie Mac is a good example of how far some companies will take this. Early last decade, management was so concerned with delivering consistent results that it engaged in wholesale accounting fraud to underreport earnings that began growing faster than normal. Ironically, in an attempt to appease shareholders, management undermined them. Though paying low dividends in the name of stability obviously isn't fraudulent, the companies that do so are doing shareholders a similar disservice
Managing expectations didn't work for Reserve Primary. It didn't work for Freddie Mac. And it won't work for most stocks. Business is inherently volatile. Dividends should be, too.