Cash flow and dividends

28Nov05

Ian McDonald at the Wall Street Journal continues their coverage of the Savings Glut. Cash rich U.S. companies have increased their dividends and stock buybacks to the tune of 30% in 2005.

The issue is played as a good news/bad news situation. The good news is that after the tax law changes making dividends more attractive companies have responded to these incentives and are finally devoting more cash flow to dividends. Dividends had become passé, but even after these increases have only rebounded to 32% of earnings vs. a historical norm of 54%.

The bad news is that some analysts feel that the accumulation of the cash hoard and the disbursement of it to shareholders via dividends and buybacks is indicative of a lack of faith in the U.S. economy. That is, there are not enough attractive investment opportunities; therefore management is being forced to offload cash.

While there is a argument for a gun-shy management class this may be short-sighted. There is some evidence that higher dividend payouts indicate higher future earnings growth. A paper by Robert D. Arnott and Clifford S. Asness in the Financial Analysts Journal argues just that. The conventional wisdom is that lower payout ratios and higher retained earnings are necessary to drive earnings growth. Arnott and Asness find just the opposite. Higher retained earnings may be indicative of empire-building and marginal investment opportunities.

Dividends are for many investors preferable to buybacks. A series of new investment funds have been designed to take advantage of the new tax preference for dividends.

“A dividend is better than a buyback for investors,” says Patrick Dorsey, head of stock analysis at Chicago researcher Morningstar Inc. “The company is saying we’re going to give you some of our income each quarter, and as a result we’re going to have to think harder and smarter about what we do with the rest of that money.”

Speaking of ample cash flows and Pat Dorsey at Morningstar.com has a screen of five star stocks, i.e. cheap according to Morningstar, with high cash returns. It is worth a look.

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