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The Releveraging of American Business

Dan Caplinger
December 4, 2012

Even as investors sit on the edge of the fiscal cliff, dividend stocks have never been more popular. Yet while many investors see dividends as a sign of financial strength, the way that an increasingly large number of companies are coming up with the cash to pay dividends suggests that at least in some cases, the opposite is true.

Yesterday, I took a look at the wave of special dividends that millions of shareholders will receive this month. That article concluded that even for companies with billions of dollars in cash reserves, sending substantial chunks of money back to shareholders represents a failure of sorts in businesses' ability to come up with profitable investments.

What's more troubling, though, is the fact that many of the companies that are paying big dividends don't have massive hoards of cash. Instead, they're turning to the credit markets, which have been more than happy to allow corporations to finance huge amounts in recent years. The result is a steady increase in overall leverage that could eventually bring back some of the problems that led to the financial crisis four years ago.

Borrowing with one hand to pay with the other
When it comes to regular quarterly dividends, investors typically look closely at the sustainability of company payouts. If a company's dividend exceeds its earnings by too wide a margin -- or, in some industries, its free cash flow -- then it raises concerns among shareholders that the company will have to rein in on its payouts at some point in the future. As a result, investors, sometimes prefer stocks with lower yields over others that have higher yields, simply because over the long run, they expect the current lower-yielder to keep paying and even increasing its payouts over time.

Special dividends, however, are another story. Historically, companies tended to make special dividend payouts when their cash levels got too high or when they received big cash windfalls. One of the most prominent examples was in 2005, when Microsoft (NASDAQ: MSFT) paid a total of $32 billion in cash to its shareholders in the form of a $3-per-share special dividend as part of a broader plan to return $75 billion in capital to investors over a four-year period. No one expects special dividends to be sustainable -- that's what makes them special.

Many companies simply aren't waiting to have cash on hand in order to pay special dividends.