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Why dividends may be losing their value

Wednesday - 6/13/2012, 11:42am  ET

Countless studies have shown that historically, dividend-paying stocks have outperformed their non- dividend-paying counterparts. But like any rule of thumb, now that everyone seems to be looking at the dividend indicator to judge future performance, you shouldn't blindly assume that any company that starts paying a dividend will suddenly rise from the ashes and outperform.

The rash of new dividends
In recent years, we've seen a host of companies decide to start paying dividends, especially in the tech arena:

  • Cisco Systems began paying a dividend last year, with its stock now yielding almost 2%.
  • Apple gave in to investor pressure to start paying a dividend following the death of former CEO Steve Jobs, with a payout of $2.60 per share due to start between July and September.
  • Most recently, Dell announced yesterday that it would initiate an $0.08 per share quarterly payout, which will result in a 2.7% yield.

In starting their payouts, companies are careful to say all the right things. Dell's CFO cited "sustainably strong cash flow from operations" as a key element allowing the company to "[add] another element to our disciplined capital allocation strategy" through a dividend. Apple's Tim Cook argued that "even with these investments [in the business], we can maintain a war chest for strategic opportunities and have plenty of cash to run our business. So we are going to initiate a dividend and share repurchase program." And Cisco's CFO noted that "Cisco's leadership position in the markets we serve is strong, and the time is right for Cisco to pay our first-ever cash dividend. ... This dividend complements our leading position, and is an important part of our commitment to bring value to shareholders."

Adding dividends for all the wrong reasons
But lately, companies have seemed to have other primary motivations for deciding to make payouts. In Dell's case, analysts argue that given its weak business results, paying a dividend invites income-hungry investors to buy shares, potentially boosting its stock price. When Apple and Cisco started paying their dividends, similar suggestions arose, as many pointed out that funds that focus specifically on dividend-paying stocks had been shut out of their shares.

More important, it's extremely hard to argue that any of these three companies has passed any relevant milestone that suddenly put them in a position to pay dividends. Apple and Cisco have notoriously huge cash positions on their balance sheets that have invited criticism from shareholders and investor advocates.

Contrast their behavior with that of other tech companies that have treated dividends more seriously. Intel , for instance, has been paying dividends consistently since 1992, and although its initial payouts were pretty puny, they've grown slowly but surely over the past decade to produce what's now a substantial yield of more than 3%. IBM isn't as generous with its dividend, which yields less than 2% after the stock's huge bull run. But with a 17-year history of raising its payouts annually, IBM is doing what every dividend investor wants to see.

Taking it out of their hands
From one perspective, paying a dividend may justify a boost in a stock's price: By taking money out of the hands of management, it makes it marginally harder for a company to make expensive acquisitions that all too often turn out to be strategic blunders. Yet with interest rates so low, the credit markets are more than happy to oblige takeover-hungry management teams by offering cheap financing.

Moreover, with many companies' questionable track record of timing stock buybacks, dividends may be a better use of capital. But when companies can't use cash profitably to reinvest in their own businesses, it marks a turning point for their growth. Investors can no longer expect the quick share-price appreciation that so many high-growth companies enjoy early on.

Don't bank on dividends
In the past, when companies were motivated to pay a dividend as soon as they possibly could, initiating a payout marked a rite of passage for a company as it emerged into sustainability. But for many companies, that motivation is gone -- and with the slew of companies paying long-deferred dividends now, you therefore shouldn't draw the same conclusions about their financial health. Only by looking at other factors can you really be sure whether a business is sound or whether a company is making a last-gasp effort to attract investors by making a dividend payout.

The best dividend stocks are great not only because of their payouts but because of the top-notch businesses that make them possible. Read all about nine of them in the Fool's latest special report on dividend stocks. With these stocks having long histories of lucrative payouts and steady growth, you won't want to miss out, so click here and get your free report today.

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