Record Cash Stockpiles Point to Fatter Dividends

After a rough couple of years for investors who rely on cash dividends from U.S. stocks, 2010 is shaping up to be a year when a dividend strategy actually pays off.

"We've definitely turned the corner," says Howard Silverblatt, a senior index analyst at Standard & Poor's.

Historically, dividends have provided a significant portion of investors' total return. For the last 20 years the prices of the S&P 500 stocks have risen an average of 6.1% per year, according to Bloomberg data. If dividends are reinvested, however, the total average annual return for the S&P 500 has been 8.4%.

A year ago many companies—particularly financial outfits—were slashing or ending dividend payouts amid a 45% plunge in fourth-quarter earnings for the broad, large-cap S&P 500-stock index. In the first three months of 2009, 46 members of the S&P 500 index either reduced or canceled their dividends. So far in 2010 only two have done so.

"There has clearly been a tremendous reversal," says Dan Genter, chief executive of RNC Genter Capital Management in Los Angeles. Companies haven't just stopped cutting dividends. They're also starting to raise them.

Other big companies hiking dividend payouts this month include Applied Materials (AMAT), with a 16.8% hike; General Dynamics (GD), up 10.5%; Public Storage (PSA), up 18.2%; Qualcomm (QCOM), up 11.8%; and Wal-Mart (WMT), which raised its dividend 11%.

The reason companies can be so generous is that many are flush with cash. By one measure, U.S. corporations have a record amount of cash and equivalents. An initial estimate based on fourth-quarter earnings issued by S&P on Mar. 9 calculates that large-cap companies have $832.4 billion, up 36.5% from when the recession began two years ago. (The estimates look at the S&P 500 index companies, excluding financial firms, utilities, and transportation outfits, all of which typically maintain high cash reserves to operate.)

That companies can have so much cash on hand after a recession is a sign of how aggressively they slashed spending during the downturn. Companies saved cash by canceling capital expenditures, laying off employees, and squeezing dividend payments. "A year ago, everyone was getting lean and mean," says John Buckingham, chief investment officer at Al Frank Asset Management.

The Pessimism Factor

Many companies, even those with stellar records of consistent payouts, had no choice but to cut dividends. Standard & Poor's keeps a list of "Dividend Aristocrats," S&P 500 companies that have increased their dividend payments for at least 25 consecutive years. In 2009 two companies joined the list, Brown-Forman (BF/B) and Cintas (CTAS). However, 10 companies left the list, including General Electric (GE), pharmaceutical giant Pfizer (PFE), newspaper owner Gannett (GCI), and U.S. Bancorp (USB).

On Mar. 16, GE's chief financial officer, Keith Sherin, said the conglomerate, after cutting its dividend 68% last year, may begin increasing its payout again next year.

Amid a tough environment, even many financially secure companies played it safe and held off on dividend increases.

"The pessimism was so bad toward the end of 2008 and beginning of 2009 that companies just cut their dividends even [if] they didn't have to," says Stanley Nabi, vice-chairman and chief strategist at Silvercrest Asset Management.

By slashing expenses, companies have been generating more cash than they know what to do with, Nabi says.

Baby Boomers Want Income

Companies can deploy their cash by buying back stock, boosting dividends, buying other companies, increasing capital expenditures or hiring workers. With economic conditions still uncertain, executives are still figuring out how to use their hoards, says Buckingham, though he expects a substantial amount of cash to go toward higher dividends. "The nice thing is that Corporate America has a lot of flexibility," he says.

Health-care companies in particular have a lot of cash on hand, says S&P's Silverblatt, who expects dividend payments by S&P 500 companies to rise 5.6% from 2009 to 2010. His 2010 projection is still 16.6% below the peak in 2008, but 2011 could see a further rise as companies announce dividend increases in the second half of the year, he says.

Silverblatt warns his estimates are based on continued improvements in the economy and a fall in unemployment.

By increasing dividends in the next few years, companies could be responding to demands from investors, particularly baby boomers approaching retirement, "who want income," Genter says.

Sales and Orders Are Crucial

Stocks that pay dividends are seen as less risky and less volatile than other equities, he adds. Dividend-payers can also provide a better payout than bonds, especially while interest rates are low.

According to Bloomberg data, the current dividend yield for the entire S&P 500 is 1.87%, based on the past 12 months, and 2.01% based on the announced payout in the next year. Only 363 of the S&P 500 companies pay dividends.

The yield on the risk-free 10-year Treasury note was 3.7% on Mar. 16.

Higher taxes proposed on dividends could reduce their appeal to investors, but dividend-focused portfolio managers like Nabi and Genter point out that taxes on dividends would still be lower than those on bonds.

The biggest threat to a full rebound for dividends could be the economy. Companies can't afford to share the wealth with shareholders if they don't see their sales and orders heading higher.

Absent another downturn, dividend-paying stocks look increasingly appealing in a low-yield world.

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