In early 2008, AIG (NYSE: AIG ) was in trouble. The mortgage market was cracking, and insurance products AIG wrote on subprime bonds were creating big losses. By midyear it was a full-fledged meltdown. In nine months, AIG lost more money than it made in the previous 18 years combined.
But something amazing happened: AIG didn't cut its dividend. From late 2007 through the summer of 2008, it actually raised its dividend payout three times. In a year that erased nearly two decades of profits, AIG paid its shareholders $2.1 billion. It wasn't until the company was taken over by the U.S. Treasury that dividends ceased due to a (very reasonable) mandate.
Why the reluctance to cuts its dividend in the face of such losses? "We are being asked why we raised the dividend," CEO Martin Sullivan said during a conference call in May 2008. "The answer is that the dividend increase is a reflection of ... management's long-term view of the strength of the company's business, earnings, and capital generating power."
This is crazy, destructive thinking, and it's pervasive among corporate managers. It's time for it to end.
Shareholders should embrace dividends that fluctuate with earnings.
Stocks are the best-performing asset in the long run because they're more volatile than bonds or cash in the short run. Most investors understand this and accept it with market fluctuations and quarterly earnings. But there's a unique standard when it comes to dividends. The market demands stability, and companies will jump through hoops to deliver.
Rarely will a company boast about the size of its dividends. Instead, many tout records of consistency. In press releases, General Mills (NYSE: GIS ) reminds of its "113-year Record of Dividends Paid Without Interruption or Reduction." This year, there have been 239 announcements of S&P 500 (INDEX: ^GSPC ) companies raising their dividends, six announcements of dividend cuts, and just one dividend cancellation. Even in 2009, one of the worst years for corporate profits in history, there were 100 S&P 500 dividend hikes and only 63 cuts.
Investors love this kind of stuff. But why? No business is stable year to year. Profits ebb and flow at the strongest companies in the world. When earnings fluctuate but dividends stay remarkably stable, there are only two possibilities. One is that companies could be paying higher dividends, but they choose to save cash for a rainy day to make future payouts. In essence, this is withholding $1 today so you can receive $1 tomorrow -- irrational if you understand the time value of money. The second possibility is that companies borrow, sell equity, and delay capital expenditures when earnings decline in order to avoid having to cut their dividends.
There's evidence of both. In 2006, Deutsche Bank published a report asking corporate managers around the world how they thought about dividend policy. While most managers from Europe, Asia, and South America took a pragmatic approach to dividends, North American managers responded in near unison that they only cut dividends as a last resort. The report wrote:
After cutting deferrable investment, North American firms would borrow money to pay the dividend, as long as they do not lose their credit rating. Next, they would sell assets at fair value and cut strategic investment. Only if all these actions are insufficient, would they resort to a dividend cut.
The most damning line was that "firms may forego projects that add value to the firm in order not to have to cut the dividend."
This has become business as usual in America: deliberately lowering long-term returns in favor of short-term stability -- the exact opposite of what stocks are supposed to provide.
Freddie Mac is a good example of how seriously some companies take this. Early last decade, management was so concerned with delivering consistent results that it engaged in accounting fraud to underreport earnings that had begun to grow faster than normal. Ironically, in an attempt to appease shareholders, management undermined them. Though paying low dividends in the name of stability clearly isn't fraudulent, companies that do so are doing shareholders an equal disservice.
Paying dividends that fluctuate with earnings would end this disservice. It would likely mean companies could pay higher dividends overall, and it would force shareholders to think of themselves as actual business owners. Fluctuating dividends are, after all, how most private businesses operate.
A couple of companies are leading the rational-dividend charge. In 2007, insurer Progressive (NYSE: PGR ) began paying out annual dividends that fluctuate based on operating performance. Cal-Maine Foods (Nasdaq: CALM ) does something similar, paying a quarterly dividend equal to one-third of net income and halting dividends when net income is negative. Its management believes "a variable dividend policy more accurately reflects the results of our operations while recognizing and allowing for the cyclicality" of its industry. It's logic that applies to nearly all companies in all industries.
Now, there is an argument to make that some investors are better off with stability, even if it means lower long-term returns. Retirees in particular may favor stable dividends to live on. These investors, frankly, shouldn't be investing in the stock market if stability is their top concern, but I can see room for compromise here. Companies could pay small, consistent quarterly dividends, with a larger 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 large annual payouts -- or not.
Business is inherently volatile. Dividends should be, too.