Special Dividend Investing Is Not Dividend Investing

by: Tim McAleenan Jr.

It's probably a safe starting premise to assume that most long-term income investors choose to own stocks that offer a great combination of two things: (1) reliable present income, and (2) income that is likely to grow at a rate above inflation indefinitely for years to come.

There's a reason why prudent dividend investors are going to be likely to own companies like Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) for the next ten years. If you look at Coca-Cola's record, you can see that the company has increased cash flow per share every year since 1999 with the exception of a $0.04 per share fall from 2008 to 2009. For Johnson & Johnson, the company has grown cash flow per share every year since 1999, with the exception of a $0.01 per share drop-off from 2008 to 2009.

And because both companies have historically returned about half of their profits to shareholders in the form of dividends, they both had the wiggle room to raise dividends every year during that period, including during the financial crisis when the dividend growth rates temporarily eclipsed the growth rates of the business themselves (long-term, this is an unsustainable practice, but the management of an excellent dividend growth firm will have the discipline to temper dividend growth during good times so that the company may maintain moderate dividend growth during rough economic periods).

This leads to my definition of what solid dividend investing usually consists of: you identify and purchase (at reasonable valuations) excellent companies that are likely to increase profits year after year (usually these are large blue-chip companies) and you also check to make sure that they have long, uninterrupted records of sharing more and more profits with their investors through good times and bad.

I'll use Colgate-Palmolive (NYSE:CL) as an example. The company is excellent, generating profits in dozens of currencies from products like toothpaste and soap. The firm has been paying dividends since the 1800s. The company has grown earnings by about 11% annually over the past ten years, and has shared that profit growth with investors by growing dividends by 12% annually over the same time frame. While there are no guarantees about the future, I feel more comfortable putting my money into companies that seem to be relentless in increasing profits year after year, as opposed to betting on something bold and new to shake up the industry and take over.

What I outlined above is in no way similar to special dividend investing. For instance, AOL (NYSE:AOL) has recently declared a special cash dividend of $5.15 per share. But guess what it is? A return of capital. As the IRS explains it, "Distributions that qualify as a return of capital are not dividends. A return of capital is a return of some or all of your investment in the stock of the company. A distribution qualifies as a return of capital if the corporation making the distribution does not have any accumulated or current year earnings and profits to cover the distribution." It's difficult to develop a general rule about special dividends because the facts surrounding each company paying them are quite different, but it is possible to say this: the practice of paying large special dividends is a short-term phenomenon that is here today, gone tomorrow. The practice of owning excellent companies that pay more and more regular dividends each and every year is often part of a cogent long-term plan.

The odds are, if you are reacting to a one-time special dividend, you are already late to the party. Costco (NASDAQ:COST) and Brown-Forman (NYSE:BF.B) are the two big-dog blue chips that have declared special dividends so far, and the declarations have caused the valuations of both firms to go above 25x earnings, which is notably above their historical P/E ratios over the past fifteen years (when removing the dotcom bubble valuations excess). After the special dividend, the valuations of both companies will probably come closer to historical norms, and the companies will have worse balance sheets in the process because the dividends were not funded from profits alone.

The beauty and purpose of long-term income investing is that investors receive larger and larger dividend checks that are the result of the company generating larger and larger profits. That is a sustainable long-term practice. Right now, the fad of taking on debt or taking a sledgehammer to balance-sheet strength to fund a special dividend is a temporary phenomenon that will likely be with us for the rest of the month, and the ability to profit from this latest fad will largely hinge on your ability to make intelligent (or lucky?) speculations. As fun as it might be to receive a 7% return on investment in a single day in the case of Costco, it is probably best to remember: if it seems too good to be true, it probably is. I'm interested in receiving checks in the mail that come from profits, not temporary accounting maneuvers, gimmicks, and balance-sheet reshuffling.

Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.