In Praise of Cutting Dividends

What is the relationship between a stock’s dividend and its price? Complicated,

obviously. The best-performing stocks and companies often have no dividend at

all – Microsoft paid out $0 from the date of its IPO all the way through

to its all-time high at the beginning of 2000. And companies which announce

big changes in their dividend don’t always see much in the way of stock moves:

when Microsoft started paying dividends in 2003, the stock went nowhere.

This all makes intuitive sense. Shareholders generally own stock in any given

company because they believe in management’s ability to get attractive returns

on capital. If a company retains its earnings rather than paying them out in

dividends, that just means there’s more capital for them to get attractive returns

on. Besides, shareholders still own that money, either way.

More generally, there is some optimum level of dividends for any company. The

more that the dividend differs from that level, in either direction,

the more that the share price should fall.

Yet Paul Murphy, today, seems

convinced that the only natural order of the world is that higher dividend

= higher share price.

We’ve been slow to recognise that one aspect of the ongoing credit

malarky, is that amongst both market participants and market observers, many

are increasingly ready to read “down” as “up,” “red”

as “black”, and “bad” as “good.” Witness

Monday’s 215 spike on the Dow. Witness,

even, Portfolio’s Felix Salmon:

…while Citi’s shareholders are by no means guaranteed their

dividend. On the other hand, any cut in the dividend might conceivably result

in a rise in Citi’s share price, if shareholders are convinced it

would put the bank on a much more sustainable footing going forwards.

Yes, cut the divi and the stock’s a ‘buy,’ apparently.

Well, I wouldn’t go that far. But I certainly don’t think that cutting the

dividend is necessarily bad for financial stocks, "credit malarky"

or no. Just look at Freddie Mac today: it cut

its dividend in half – and announced further equity dilution, to boot

– and yet soared by more than 9% at the opening bell as a result.

Might Citi find itself in the same boat? I don’t see why not. Yes, it does

have a good number of shareholders who have come to rely on that dividend and

who would be very unhappy were it to be cut. But what are they going to do,

sell the stock at these depressed levels? That would only compound the injury.

Meanwhile, Citi’s bolstered capitalization would help it regain its lost and

latent strength.

If you went to business school, you might have been taught at some point that

the value of a stock is simply the net present value of future dividends. On

that view, a dividend cut is likely to hurt the share price unless the company

can compellingly persuade shareholders that there will be an offsetting, larger

dividend increase in the future. But no one really believes that model of pricing

equities, especially now that the technology sector has shown that companies

can grow in share price and size more or less indefinitely without paying any

dividends at all. In the real world, cutting back on dividend payments can be

a smart thing for a board to do. Maybe if Freddie’s board had cut the dividend

entirely, its stock would have risen even further.

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