There is more than meets the eye to Cisco's
Yes, they can (own the stock)
When Citigroup eliminated its dividend in 2009, many mutual fund managers and other institutional investors were required to sell the stock. That's because their investment policy only permitted investments in dividend-paying stocks. The mandatory rush for the exits when a dividend is eliminated can really punish a stock's price. In contrast, cutting the dividend to $0.01 may have spooked many investors out of Citigroup stock, but the penny dividend didn't force them to sell. They could even decide to buy more.
Any dividend -- even if it's just $0.01 -- opens up a whole new class of potential buyers for a stock ... and it's not just value investors.
Now they must (own the stock)
For some investors, a dividend is a mandatory rush for the entrance. With the initiation of a dividend, Cisco becomes a must-own stock for dividend-only index funds. These include (but are not limited to) the iShares DJ Select Dividend Index
Dividend-based funds typically allocate assets in proportion to the size of the dividend, so the 1.4% forward yield on Cisco will create a lot more demand than a much lower yield.
Vive la différence
Will forced buying by index funds make a difference for Cisco stock? As it turns out, index funds are prominent among Cisco shareholders. The three largest holders, which own more than 11% of shares outstanding, are the three big index fund managers: State Street Global
Six of the 10 biggest holders of Cisco stock are not deciding to buy it because they like it. They just do what the index tells them to do. Initiating a dividend creates incremental demand among this important group of potential buyers. Economics 101 says more demand with no increase in supply typically drives up prices.
What's more, Cisco -- historically a growth stock -- is looking more like a value stock lately. Although management is targeting growth of 12% to 17% per year over the coming three to five years, investors seem skeptical. They should be. In Cisco's most recent quarter, EPS fell to $0.37 from $0.40 a year earlier. Analysts are forecasting year-over-year EPS declines for the coming two quarters and an EPS decline for fiscal 2011, which ends in August.
It is no wonder growth investors have largely bailed on the stock, which is trading at a paltry 10.4x P/E ratio. That is the kind of multiple that attracts value investors. And value stocks are associated with dividends. Cisco announced it is targeting a dividend yield of 1% to 2%, and its $0.06 quarterly dividend produces a forward yield of 1.4%.
Offering a dividend won't restore impressive EPS growth to Cisco. But the stock could use some buyers, and its recent results won't attract growth investors. Initiating a dividend forces buying by some institutional investors and creates an additional group of potential buyers among institutional investors that are restricted to dividend-paying stocks. It also makes the stock more appealing in general to value investors, a group suitable to the company's recent results. With about three-fourths of Cisco's stock held by institutions and index funds prominent among its top holders, Cisco needs the incremental demand the dividend creates.
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Fool contributor Cindy Johnson does not currently own shares in any of the companies or ETFs in this story. BlackRock is a Motley Fool Inside Value pick. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Alpha LLC owns shares of Cisco Systems. 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.