Doc Eifrig: Dividends are disappearing in America. Here’s why…

From Dr. David Eifrig, MD, MBA, editor, Income Intelligence:

In a time when U.S. income investors need yield the most, dividends are declining.

Back when stocks were first created, investors had different expectations as part-owners of a company. They bought stocks to share in the profits by receiving dividend checks. Over time, the purpose of stocks shifted away from dividends and toward capital gains and growth.

One of the first stocks – the Dutch East India Company, established in 1602 – paid shareholders 5%-7% a year… though sometimes, shareholders would get their “dividends” in the form of a bundle of cloves or spices.

In 1934, value-investing experts Benjamin Graham and David Dodd published Security Analysis. The book laid out the tenets of value investing. In it, Graham and Dodd noted matter-of-factly, “The prime purpose of a business is to pay dividends to its owners.”

You wouldn’t think that was the case by looking at U.S. stocks today. Only around 25% pay a dividend. That’s down from nearly 60% in 1980. (It was as low as 15% in 2002.)

At the same time, interest rates remain near zero percent. Income investors are desperate for yield. And over the last five years, they have flocked to dividend-paying stocks. Since 2009, dividend-paying stocks (as measured by the Dow Jones U.S. Select Dividend Index) are up more than 150%. Meanwhile, the market (as measured by the S&P 500) is up around 110% over the same time frame.

Remember… the S&P 500 also includes 86% dividend-paying stocks. If you removed the dividend-payers, the performance difference would be even more staggering.

As regular Income Intelligence subscribers know, it isn’t easy to find investments paying steady income. Last Fall, we dubbed this period “the Dark Ages of Income Investing.”

Fortunately, although yield may be tough to find, our returns have been strong. We recently e-mailed out a portfolio review that showed that our positions have returned 29% on an annualized basis since our recommendations. That number includes both dividend payments and capital gains. So far, we’re successfully navigating the Dark Ages.

But the questions remain: Why are healthy dividends scarce? And where can we find stable yields at a good value?

Why Dividends Have Declined

As we mentioned above, the purpose of the stock market has changed over the years… from a place to earn a consistent dividend return to one designed to find the next big growth company.

Nobel Prize winner and S&P Case-Shiller Index cofounder Robert Shiller found that from 1872 to 1985, the S&P 500’s dividend yield rarely dropped below 4%. Since then, it has fallen in a nearly straight line to 2%, where it sits today.

And yet, the S&P 500 has more than doubled over the last five years, which has driven yields down. (Remember, prices and yields move in opposite directions.)

On top of that, companies have tightened their belts with dividends. Through the first half of the century, companies in the S&P 500 typically paid out 60% or so of their income as dividends (also known as the “dividend-payout ratio”). The number rarely fell below 50%.

But over the last 20 years, the dividend-payout ratio has drifted down to around 33%…

Part of this is that CEOs feel they can generate a better return than individual investors. That’s the case in some companies – like Warren Buffett’s Berkshire Hathaway. But it’s not true for most companies.

Another reason companies are hesitant to pay a dividend is that investors have been known to punish stocks that turn into dividend-paying stocks.

On one hand, paying a dividend should be a sign of stability, financial health, and consistent profits. But for growth stocks, it can be a sign of weakness. For example, if search-engine giant Google announced a dividend tomorrow, the market would likely respond by pushing shares lower out of fear that there’s no more growth left in the business.

In theory, when a company agrees to pay a dividend, it isn’t required to continue to pay that dividend forever. But in reality, cutting a dividend can send a stock spiraling lower… And it’s usually a bad sign for the company.

Keeping the cash in a company’s pocket allows for a bigger safety cushion. Instead, companies are more likely to turn to a cheaper way of rewarding shareholders…

A Cheaper Alternative to Paying Dividends

Today, fewer companies are paying dividends. Instead, they’re turning to share repurchases (called buybacks).

Rather than paying out cash in the form of dividends, companies are purchasing their own shares and retiring them. This is one way of rewarding investors, since it means their shares equal a larger piece of the pie. The fewer slices of pie outstanding, the bigger your slice is.

Over the last 12 months, companies have bought back $535.2 billion worth of shares, according to research firm FactSet. That’s up from around $130 billion in 2009. It’s huge.

The logic of a buyback is simple. If a company earns $1 per share and is priced at 15 times earnings, its share price is $15. If the company buys back 10% of its shares, its earnings rise to $1.11 per share (assuming the business stays steady). If the company is still priced at 15 times earnings, its share price will rise 10% to $16.65.

Management teams prefer buybacks because they don’t need to continue them when times get tough… And they won’t get punished for not continuing to buy back shares.

Plus, there are the tax advantages. When taxes on dividends are high, companies favor buybacks. In 2003, President Bush cut taxes on dividends to 15%. Over the next two years, 145 companies initiated dividends. But today, the equation has flipped. Taxes on dividends are rising again, which is shifting companies toward buybacks.

Companies are returning more money to shareholders – just not through dividends. This year, companies are on pace to return 45% of their cash to shareholders. That’s the highest level since 2007. The remaining 55% goes toward capital expenditures, research and development, and acquisitions. Today, companies are spending nearly twice as much money on buybacks as they are on dividends.

Clearly, companies are increasing shareholder value. And it’s better to see a company buying back shares rather than sitting idly or making foolish acquisitions. But as income investors, buybacks aren’t ideal for us.

Sure, buybacks drive share prices higher, but not in a way that income investors can count on like they can with steady dividend payments. And the trend toward buybacks doesn’t look like it will slow down any time soon.

Yields on fixed income are low. Rising interest rates threaten fixed-income investments. We don’t think it’s imminent, but inflation could heat up at some point. The geopolitical situation in Ukraine and the Middle East is unstable right now. In other words, where the market is headed next is anyone’s guess.

But for income investors, the path to follow is obvious: we need to look at investing overseas.

We suspect that over the next 12 to 18 months, this theme will become a significant part of our portfolio, leading us to higher returns and lower risk.

Crux note: To find out how Doc’s readers are collecting BIG, SAFE income overseas, try a 100% risk-free subscription to Income Intelligence. Click here to get all the details.

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