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Traditional thinking about dividends is that low-paying stocks provide greater growth potential, because the company is fueling future growth by plowing more money back into the company. The so-called “sustainable growth model” (SGM) is based on this concept, holding that the maximum growth rate is achieved with zero dividends paid out. Stated another way, SGM purports to show that when a firm pays dividends, earnings growth lessens.

Does that academic formulation really play out in the real world? In the best Sensible Stock Investing tradition, let’s toss aside conventional wisdom for a moment, start with a blank sheet of paper, and think about this.

The first thought that comes to mind is that—in an established company with a long-standing tradition and practice of raising its dividend annually—the amount by which a company raises (or lowers) its dividend gives great insight into what company management sees in its future. In other words, the amount by which a company raises its dividend is a leading indicator of how management sees the company’s fortunes over, say, the next two-three years. Furthermore, in contrast to SGM, common sense suggests that the higher the dividend increase, the better the outlook for the company. Not only must current cash flow be plentiful (to pay the dividend), the dividend declaration probably reflects management’s confidence in the stability and growth of future earnings, quite possibly based on information that is not publicly available.

In the lead article of this month’s AAII Journal (written by Stanley Block), this idea is buttressed by a discussion of two studies performed in 2003 and 2006. In a nutshell, the studies found that higher dividends = higher earnings growth. One study was done with aggregate market data; the other used stock-by-stock analysis. The authors of the latter study stated, “Our tests…show that high-dividend-payout companies tend to experience strong, not weak, future earnings growth.” (AAII Journal, May 2009, p.5.)

Why should that be? Several reasons:

-First and most obviously, SGM assumes that retained profits will always be used wisely in a way that creates value and growth. But in the real world, retained profits are not always used wisely. I have worked in large corporations and seen examples of dumb capital allocation: Ridiculous pet projects, over-priced acquisitions, out-of-control pay and bonus structures, multiple false starts on good initiatives (like IT upgrades), overstaffing at the top while squeezing the real wealth creators who do the work, constant reorganization with high collateral expenses (and often damage)—the list is long.

-As stated in the AAII article (and I have definitely seen this too), “high earnings retention…may signal an attempt at empire-building by current management.”

-And “management may engage in developmental projects that do not represent the best interests of stockholders.”

-And “the main recycling [of potential dividend dollars] has been toward share repurchases.”

As I have stated elsewhere, a company that pays dividends will probably invest the earnings it does retain more carefully. The dividend program imposes discipline on management. With less money to play around with, management will tend to be more careful about what it does with the remaining money.

There are several interesting tables in the AAII article. Two of the tables compare the dividend yields and stock price performance of the 30 Dow Jones Industrial Average stocks between 1/1/04 and 6/30/08, a period of 4 ½ years. Dividing the stocks into two groups—those that yielded more than 2% or less than 2% at the beginning of the period, the author demonstrates that the higher-yielding stocks far outperformed the lower-yielding ones. For the duration of the period, the 16 higher-yielding stocks averaged a capital gain of 32% (median 20%). The 14 lower-yielding stocks averaged capital gains of -1% (median +2%). The difference could hardly be more stark. (For comparison, over the study period, the DJIA was up almost 9%.)

Now obviously, the proposition that high-yielding stocks outperform low-yielding stocks is not foolproof. In the study, not every high-yielding stock performed well. For example, General Motors (NYSE:GM), with a 4.2% initial yield, lost 76% in price during the study period. And not every low-yielding stock performed poorly: Hewlett-Packard (NYSE:HPQ), with an initial yield of 1.4%, rose 92% in price. But the averages and medians of the complete lists were as stated above.

As the author of the AAII article states, the reasoning about dividends does not apply to young companies, who generally must retain all of their earnings to fuel their early growth. Another caveat is that having a well established dividend-raising culture and practice does not guarantee that a company is not in trouble. Management sometimes misgauges. Nowhere has this been more true than in the financial industry over the past year or two. I’ll have a little more to say about such companies at the end of this article.

I follow several dozen dividend stocks, all of which have solid dividend-raising cultures. (Those are the only logical stocks for a dividend investor to consider.) Many have raised their dividends for 20-25 years or more. So far this year, several of them have declared significant dividend increases: Abbott (NYSE:ABT) 11%; Coca-Cola (NYSE:KO) 8%; Colgate-Palmolive (NYSE:CL) 10%; and Procter & Gamble (NYSE:PG) 10%. I would say that for each of these companies, the strong dividend increase signals that management feels it has good visibility of healthy earnings growth over the next couple of years (at least). No one on the management team in any of these companies wants to raise the dividend to such an amount that there is any danger that they might have to freeze or cut it in the future.

On the other hand, some of the companies I follow, while also long-term dividend raisers, have declared increases this year that are tepid or little more than symbolic: Air Products (NYSE:APD) 2%; AT&T (NYSE:T) 3%; Sherwin-Williams (NYSE:SHW) 1%; and 3M (NYSE:MMM) 2%. These small increases suggest that management is unclear about the next year or two, and therefore is avoiding the possibility of a future freeze or cut by holding this year’s increase to a nominal amount. That keeps their streak of consecutive increases going, but (hopefully) does not endanger it in the future by setting the dividend so high that it cannot continue to be increased. Management is prudently taking a breather during hard times.

And, of course, there are companies in the middle, raising their dividends neither by really large amounts nor playing defense with tiny increases. Examples would be Chubb (NYSE:CB) 6%; Waste Management (WMI) 7%; PepsiCo (NYSE:PEP) 6%; and Southern (NYSE:SO) 4%. Given the general economic climate, these increases are actually pretty good, but they also reflect a cautious attitude. That is totally fine with me as a dividend investor. I want these companies to be managed prudently, and for them to spin out increasing dividends for years to come.

What about companies that have cut their dividends? Only one that I follow closely (Diageo, DEO, -25%) falls into this category so far this year. Clearly, I think this reflects the company’s felt need to conserve capital as they look at a future performance outlook that is at best unclear and may well be negative.

One can’t talk about dividend slashing without thinking about what has gone on with banks. Many of them have severely slashed or even eliminated their dividends during the past year. That fits perfectly with the earlier premise: If healthy dividend raises suggest healthy future earnings growth, then dividend cuts suggest cloudy or unattainable earnings growth. Obviously these are companies in trouble.

Interestingly, for several months, most of their trouble was predictable from basic analysis of their financials, or from their “stories” (including acquisitions made or TARP funds taken). I am surprised that these stocks remained on some “dividend buy” lists right into 2009. One, BB&T (NYSE:BBT) continued to be held by at least one highly respected dividend writer right up until—well, right up until it slashed its dividend last week by 68%.

Here’s my two cents on banks as dividend investments:

-Most banks must be considered speculative investments until further notice. For the long-term dividend investor, that means you can take almost all of them off your watch lists.

-That especially applies to banks that took TARP funds. Their focus is now forced to be on capital building and repaying TARP. Many are issuing scads of new shares as one avenue to raising capital. BBT, for example, is selling 15% more shares. Their focus cannot be on restoring their former dividend.

-Traditionally, banks have been reliable dividend generators. There is absolutely no guarantee that they will return to that status anytime soon. Nobody knows whether the general rule that "banks pay good dividends" is still true. We may be seeing a paradigm shift in what it means to be a bank, especially with all the current government involvement and new banking regulations likely in the offing.

-Even after the current climate ends, and banks are out from under direct government involvement, there is no way to predict when they will be able to regain the earnings-generating capacity that would be required for them to be the dividend payers they once were. I have seen blithely confident statements that banks will be back to their old dividend-paying ways shortly, like in a year or two. I have no idea how anyone can be confident about that.

Finally, not so long ago, the troubled banks were on S&P’s Dividend Aristocrat and similar lists of companies with many years of uninterrupted dividend growth. What happened to them underscores why such lists are just starting tools for the attentive dividend investor. Each stock must be examined one at a time for its business standing, its financials, and whether its dividend is at risk. Dividend investing is a long-term strategy that must be executed carefully. Every stock that pays a dividend is not an appropriate holding for a serious dividend investor. And once purchased, dividend stocks cannot just be stuck in a drawer. One should review all holdings once or twice per year and analyze them to see which companies, because of their business situation, are likely to need to cut their dividend to preserve cash. Most dividends in peril are predictable.

Disclosure: Long ABT, CL, PG, T, SHW, MMM, PEP, and SO

Source: Dividends: A Company's Leading Indicator