The Case for Flexible Dividends

Worldwide Invest Better Day 9/25/2012

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.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Motley Fool newsletter services have recommended buying shares of American International Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (26) | Recommend This Article (33)

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 September 07, 2012, at 3:56 PM, sheldonross wrote:

    Correct me if I'm wrong, but isn't this more the norm in Europe and other areas?

    For some reason Americans applaud consistency even if ultimately detrimental.

  • Report this Comment On September 07, 2012, at 6:15 PM, HowardLAX11 wrote:

    Great article, I would like to see flexible dividends as well. Special dividends would be a good compromise.

  • Report this Comment On September 07, 2012, at 7:51 PM, Johnnyrz wrote:

    Not all of your readers are in their working years. I can assure you that as a retiree I depend on steady dividends. Even these returns, although steady for the most part, are paltry. So, your comment that retirees should not be investing in the stock market, taking into consideration these times, is a bit naive when one looks at the all other sources of "stable" and relatively safe returns. There are corporate bonds of course that carry varying degrees of risk, but even these returns are nothing to call home about. With the Fed keeping interest rates at near zero and thus eliminating many other sources of income, where else are retirees to go to make a decent living? I personally long for the 5 1/4% return that we all got on passbook savings at almost any bank in the past. How nice would that be with no fees etc. to eat into ones income!

  • Report this Comment On September 07, 2012, at 7:52 PM, LoricLost wrote:

    Come and talk to me when you're 70. Your Darn right retires care, and right now, my friend, stocks are the only game in town. Or do you have some secret way to get income that beats inflation!

  • Report this Comment On September 07, 2012, at 9:00 PM, jabez1 wrote:

    Consistent dividends instill discipline in otherwise undisciplined managers and provide support for the stock price which allows new shares to be sold at a higher price to provide money for value added projects.

    If there are still more value added projects they can be financed with debt just as effectively and maybe they will be screened a little closer.

    Creditors expect regular payments and so should owners.

  • Report this Comment On September 07, 2012, at 10:27 PM, ICE9RAKER wrote:

    Clearly - you don't get it! -- no, - never reduce a dividend - always have a base dividend -- then special div - if it warrants - people depend on divs. - never cut. if a company cuts div - bad planning, bad mgt, bad budgeting etc. get out - can't trust them.

    C

  • Report this Comment On September 08, 2012, at 12:16 AM, SuntanIronMan wrote:

    If the majority shareholders want consistent dividends, they should get consistent dividends.

    If the majority shareholders want flexible dividends, they should get flexible dividends.

    It really should not be too much more difficult than that.

    Just so happens that in the US, we prefer our dividend-payers to be consistent dividend-payers. The market has spoken. And it is not just retirees who like consistent dividend-paying companies. I am in my 20s and I like those companies as well. Like you mentioned though, there are some US options for those who do want flexible dividends. And if you look overseas, you can find many of them. I have a few such foreign flexible dividend-paying companies in my portfolio.

    There are options out there for those who want them. If you do not like a company's dividend policy of consistent-payments though bad times and good times, you do not have to invest in said company.

  • Report this Comment On September 08, 2012, at 11:58 AM, ershler wrote:

    I understand old people are not really interested with long term results since the odds they will be around to collect on them are not great. I guess everyone else gets stuck with lower performance.

  • Report this Comment On September 08, 2012, at 12:58 PM, DivdsRtheReason wrote:

    Dividends are the original reason for buying stocks as an investment. Chasing the big one has been a more recent phenomena. You always read you can't time the market so - as an investor I look for good solid companies and yes dividends is a way to invest. If the Exec's took pay cuts and shared the wealth from the top more and were honest dividends should fluctate but not as the course of business and a way to get more pay to the top for the big Fortune 500 companies, pay the workers less, take away benefits and trickle the dividends. That is NOT what I want to see in the future.

  • Report this Comment On September 08, 2012, at 5:58 PM, mky517 wrote:

    Why not have both systems operate in the marketplace? Why do we have to have just one or the other ? The author of the article strikes a high moral ground by telling the oldies to get out of the marketplace. How stupid can some writers get ! Why not slash the rapacious salaries of the CEO's in response to companies misfortunes due to stupid management ? Consistent dividends do not make or break the company. Stupid and shortsighted management will always kill a company before dividends wil ever kil a company. That is my take. Flexible dividends ? Bah Humbug !!

  • Report this Comment On September 08, 2012, at 8:25 PM, dgmennie wrote:

    I mean think about it. Stock dividends are already as flexible as they can get -- you either get paid or you don't, all at the company's discretion. Retired folks don't buy this stuff with the hope of bagging a windfall ten years from now. They need dependable cash flow to pay the bills. Contributors mky517 and DivdsRtheReason have it about right. Frankly, there are no CEOs worth what they are being paid right now. And this goes for a whole host of management hanger-ons who pocket the big bucks. Pay the dividends you idiots. Otherwise the stock certificates should be used for wallpaper.

  • Report this Comment On September 08, 2012, at 9:25 PM, alvidovich wrote:

    I enjoyed your article and I think you made a good argument for dividends that fluctuate. If the company does that, it also gives you a pretty good clue as to how the company is doing. Thank you.

    Al

  • Report this Comment On September 09, 2012, at 10:01 PM, DividendsBoom wrote:

    Point taken, but if you have a company with a high credit rating, and a reasonable payout ratio with reasonably consistent earnings, a non-fluctuating dividend shouldn't be too difficult. They can access credit markets at a reasonable price to fund growth.

    The problem is when highly cyclical companies try and fit the bill described above they end up with extra cash at the top of the cycle that they dont feel compelled to pay out. Instead they invest high, and likewise when they are flush with opportunities at the bottom of the cycle, all of their earnings and then some go to dividends. I like the approach CME is taking, regular dividend plus special.

  • Report this Comment On September 10, 2012, at 10:56 AM, truman1987 wrote:

    One of the problems with a special dividend is that the online tools mix them up with regular dividends. Google Finance Seadrill SDRL. According to the Google chart it looks like they paid $0.76 on 12/8/11, $0.80 on 3/8/12, $0.15 on 5/22/12 and back up to $0.84 on 9/4/12.

    What Google reports as a dividend decrease in May was actually a special dividend on top of an $0.82 dividend for a total of $.097 that quarter.

    There was even an article about Seadrill that brought up the concern that their dividend was volatile because the author didn't realize that this was a special dividend.

  • Report this Comment On September 11, 2012, at 3:23 PM, idanpl wrote:

    IIUC, REIT companies pay >=90% of their taxable income as a dividend, and therefore, their dividend is aligned with their actual earnings.

    ShedlonRoss, I live in Israel, and in here, it feels like the dividends are indeed aligned with the earnings.

  • Report this Comment On September 11, 2012, at 3:29 PM, pondee619 wrote:

    "Stocks are the best-performing asset in the long run (BECAUSE) they're more volatile than bonds or cash in the short run."

    Really? It's the volatility that causes stocks to be the best-performing asset in the long run?

  • Report this Comment On September 11, 2012, at 3:44 PM, TMFMorgan wrote:

    Yes. If they were less volatile and more predictable, valuations would rise and future returns would fall.

  • Report this Comment On September 11, 2012, at 4:11 PM, TMFBlacknGold wrote:

    I wrote a similar piece for the Blogging Network titled "When Slashing a Dividend is the Right Move":

    http://beta.fool.com/blackngold/2012/05/14/when-slashing-div...

  • Report this Comment On September 11, 2012, at 5:38 PM, cheeees wrote:

    Last month US Mobility, Ticker USMO, cut their dividend in half and initiated a share buyback program. The stock fell. I bought it 2 years ago because I wanted access to their huge yield, not so management could manipulate Earnings Per Share with stock buybacks. And not so I could own another stock deeper in the red. I'd rather take consistent reliable dividend any day and I'm under 30

  • Report this Comment On September 12, 2012, at 2:53 PM, pondee619 wrote:

    TMF Morgan:

    "Yes. If they were less volatile and more predictable, valuations would rise and future returns would fall."

    Are you kidding? Rising valuations ARE the definition of an out performing issue, be it stock, bond or cash. Don't stocks, as the better performing asset, rise faster and, therefore, according to you as cited above, future returns would fall? Stocks do not out perform BECAUSE they are volatle, they out perform and are volatile.

  • Report this Comment On September 12, 2012, at 2:58 PM, TMFMorgan wrote:

    ^ Future returns are inverse to starting valuations. When valuations surge, future returns fall.

  • Report this Comment On September 12, 2012, at 4:43 PM, BigFatBEAR wrote:

    Great article per usual, Morgan!

    To all the responding retirees: stocks are NOT the only game in town. Have you looked at LendingClub? There's tons of financial innovations out there, time to explore 'em. Good risk:return scenarios are out there!

  • Report this Comment On September 13, 2012, at 8:57 AM, pondee619 wrote:

    But isn't it the rising valuations that make them out performers? Surging valuations=outperformers.

    "If they were less volatile and more predictable, valuations would rise..." So, it is the less volatile and more predictable stocks that out perform until they reach their full valuation and level off.

    There is no cause and effect between volatility and out performance. Volatility does not CUASE out performance any more than it causes under performance on downside volatility. Volatility and performance are traits of an issue. Volatile stocks may out perform the market, they may also substancially under perform the market, they may, for a while, match the market. Volatility does not CAUSE outperformance.

  • Report this Comment On September 13, 2012, at 9:05 AM, TMFMorgan wrote:

    <<But isn't it the rising valuations that make them out performers? Surging valuations=outperformers.>>

    We're talking about future returns. This is why those who bought the nasdaq in 1999 haven't done too well since.

  • Report this Comment On September 16, 2012, at 5:43 AM, thidmark wrote:

    "These investors, frankly, shouldn't be investing in the stock market if stability is their top concern"

    Ideally, this is true. Of course, ideally, our government shouldn't be printing trillions of dollars.

  • Report this Comment On September 17, 2012, at 3:20 PM, pondee619 wrote:

    So, the NASDAQ wasn't volatile in 1999? It not volatile leading up to 1999? Did the NASDAQ rise pre 1999 because it was less volatile and more predictable? I thought your premise was that the more volatile the issue the greater the return.

    Stocks offer the better chance of out performance AND they can be more volatile,. They do not offer the better chance of a return BECAUSE they are more volatile

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