Embracing Wild Dividends

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.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Fool owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure  policy.


Read/Post Comments (21) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2011, at 6:39 PM, rlp2451 wrote:

    I'm not sure what the author's point is here. Buy low, sell high? Expect companies to cut their dividends?

    If one does their own due diligence, they should be able to tell well in advance when and if a company is in danger of reducung or eliminating their dividend.Some people hang far too long on their stocks because they have had them for so long, but if fundamentals change, you should REALLY take a close look to decide whether or not you should keep or sell it.

  • Report this Comment On June 21, 2011, at 8:02 PM, Smitmiller wrote:

    I might also be missing the point.

    Absolutely, with higher returns comes higher volatility. A company with steady dividends doesn't flaunt this rule, nor do the shareholders who invest in it; indeed, they're abiding by it. They're not unrealistically demanding no volatility, just less volatility.

    They agree to slightly lower returns (the time value of the money that's not given out in dividends, for example) for lower volatility. The risk and reward are lower for these "tame" dividends than for your "wild" dividends and higher than for cash under the bed.

    But again, it's lower volatility, not no volatility, and perhaps that's really your point, that such investors are under the illusion that they are somehow safe by making this choice. If so, they are mistaken, and the market will eventually teach them that if they don't learn it earlier from a more forgiving school.

    It's up to the investor to remember that, tame or wild, under the right/wrong circumstances any investment can gore.

  • Report this Comment On June 21, 2011, at 8:04 PM, Smitmiller wrote:

    I might also be missing the point.

    Absolutely, with higher returns comes higher volatility. A company with steady dividends doesn't flaunt this rule, nor do the shareholders who invest in it; indeed, they're abiding by it. They're not unrealistically demanding no volatility, just less volatility.

    They agree to slightly lower returns (the time value of the money that's not given out in dividends, for example) for lower volatility. The risk and reward are lower for these "tame" dividends than for your "wild" dividends and higher (theoretically) than for cash under the bed.

    But again, it's lower volatility, not no volatility, and perhaps that's really your point, that such investors are under the illusion that they are somehow safe by making this choice. If so, they are mistaken, and the market will eventually teach them that if they don't learn it earlier from a more forgiving school.

    It's up to the investor to remember that, tame or wild, under the right/wrong circumstances any investment can gore.

  • Report this Comment On June 21, 2011, at 8:10 PM, ragedmaximus wrote:

    when the shi.... hits the fan dividends turn into a bag of poop

  • Report this Comment On June 21, 2011, at 9:07 PM, scavanna wrote:

    I would much rather invest in a management that provides for the up and downs by maintaining cash both for the business and for its stockholders.

  • Report this Comment On June 21, 2011, at 9:28 PM, PeyDaFool wrote:

    Morgan,

    Personally, I like your idea of paying a dividend based on earnings. Of course, I wouldn't want every one of my dividend payers to abide by this rule, but it's interesting nonetheless.

    I could see a company like Visa, who has a small dividend and small payout ratio, to try something like this. I don't think their dividend is sought after by income investors because it's so small, so it might be an interesting experiment to try.

    You always seem to come up with new and interesting ways of explaining known topics. I definitely appreciate your articles, man.

  • Report this Comment On June 21, 2011, at 9:38 PM, TMFHousel wrote:

    ^ Thanks!

  • Report this Comment On June 21, 2011, at 9:59 PM, benthalus wrote:

    Agreed, please keep writing.

  • Report this Comment On June 22, 2011, at 12:42 AM, vgaymer wrote:

    I've thought about this idea before, and I think this may be the way some foreign companies pay dividends(proportional to earnings)

    Cheers,

    G

  • Report this Comment On June 22, 2011, at 10:16 AM, FutureMonkey wrote:

    "that is how privately owned business operate"

    Exactly right! And that is the fundamental idea of owning shares in a business.

    My business pays out to the owner (me) only when net profit margin is 10% of gross or higher and is capped at 10% each quarter. So if or margin is 5% this quarter, no return is paid and the money stays in the business account. If margin is 15%, 10% is returned to owner and 5% returned to the business. That way I build a strong cash position to expand the business, purchase equipment/inventory, or (knock wood) have reserves to pay obligations if not profitable for a quarter. As an owner, not only is their value to the quarterly return, but there is the equity value of the business, should I sell part or whole at a future date.

    I love the idea of owning shares as a silent partner in a profitable business like this. Receive a quarterly return based on profitability and build equity value as the company grows. Fundamentally owning shares in a public company should also work this way. Sadly, since much of the "value" of the shares is tied up in volatility of the publically traded market I never really have a sense of ownership, equity, or reliable quarterly return even in dividend paying companies. Most days, I'd rather invest in a local franchise rather than the parent companies publically traded stock. At least then I'd have an idea of what I owned wouldn't be subject to machinations of some hedgefund manager or momentum autotrading computer program

    Great article Morgan,

    FM

  • Report this Comment On June 22, 2011, at 10:18 AM, FutureMonkey wrote:

    muddled my their and there a few times. TMFGrammarCop while certainly issue a citation.

  • Report this Comment On June 22, 2011, at 10:28 AM, pastreet wrote:

    Dividends ensure that over time, you are getting some return, even in a horrific bear market. It's impossible to not love that. I like researching historical dividend increases before buying any stock. In many cases you see an almost perfect correlation between dividend hikes and share value increase. It's a beautiful thing.

    Pat

    www.compoundingreturns.com

  • Report this Comment On June 22, 2011, at 10:47 AM, salrycapcasualty wrote:

    Here's one U.S. company that is paying a variable annual dividend:

    http://investors.progressive.com/dividend.aspx

    The formula used to calculate the annual dividend is also used to calculate employee cash bonuses. The wild dividend looks like a good fit for PGR, given the cyclical nature of P&C insurance results.

    Maybe in the years that you don't receive a cash dividend you get a Flo bobble-head.

  • Report this Comment On June 22, 2011, at 1:37 PM, TMFBreakerRob wrote:

    My initial inclination upon hearing of this article was negative, but upon actually READING it....I think its a great idea and another fine article, Morgan.

    And that's considering that I'm also a retiree. ;)

  • Report this Comment On June 22, 2011, at 1:43 PM, TMFDiogenes wrote:

    I like this idea. It's always seemed strange that in rough times companies sometimes make decisions that are bad for their long-term well-being in order to pay out their dividends and pretend that everything a-ok. I think a regular, stable dividend plus a fluctuating special one would be ideal.

  • Report this Comment On June 22, 2011, at 3:30 PM, drborst wrote:

    Morgan, Nice article, I'm starting to wonder if the US is just weird in this respect. Most of my foriegn stocks pay out based on earnings. (I'll mention PHI which has a healthy regular payout and adds a variable component, though I think they have it backwards, they allow reinvestment of the regular payout but not the special variable portion). And thanks to salrycapcasualty for pointing out the completely the sane policy at progressive...

    I don't know why this just popped into my head, it may not be completely related, but here's an idea for congress. I've read about US companies sitting on a lot of cash that they don't want to bring home because they don't want it taxed. There are even proposals for a tax holiday to get that 'foriegn cash' back in the US. How about we don't tax foriegn earnings if it gets paid out as a dividend, it might even provide a stimulus and raise revenue (thru taxes on dividends) at the same time. Maybe someone can tell me why this isn't a good idea.

    DRB

  • Report this Comment On June 23, 2011, at 12:30 PM, 17trs wrote:

    Foriegn dividends vary more due to monetary changes than to dividend changes.

  • Report this Comment On June 24, 2011, at 2:26 PM, emersonresearch wrote:

    What's the current thought on AGNC? Obviously the dividend is sweet, but is the stock stable enough to throw some money into?

  • Report this Comment On June 24, 2011, at 3:42 PM, RichardRB wrote:

    When you use terms like "pay out ratio" in an article, shouldn't you describe how you determined it?

    What happened to the practice of regular dividends, with occasional "extra" dividends before finally raising the "regular" dividend? RRV

  • Report this Comment On June 27, 2011, at 12:11 AM, AgAuMoney wrote:

    If a company had a firm commitment to pay out a fixed high percentage, I would be OK with variable dividends.

    Problem is, very few companies have such a commitment. Further, have any kept that commitment for a "long time" ?

    MO has made somewhat of a commitment. We'll see how it goes. NPK pays a regular plus a special, but I don't recall them making a commitment.

  • Report this Comment On February 04, 2014, at 12:05 PM, williamwalker91 wrote:

    Thanks for the great article about wild dividends. I have never heard about them until this article! I think they are now important to know about.

    William | http://www.aautobuyersins.com/

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