• Log In Log Out
  • August 26, 2013

    Large U.S. companies have been enjoying high profit margins, cash flows, and levels of cash on their books. Income-seeking investors have bid up prices on high dividend yield stocks. But T. Rowe Price managers say companies could return more of the cash to stockholders through dividends and share buybacks.

    Large U.S. companies are awash in cash, and that's put the spotlight on how much of that money is going to investors via dividends and share buybacks.

    Over the last two decades, through this spring, big U.S. nonfinancial corporations' profit margins, their cash flows from normal business operations, and their cash reserves on balance sheets all have risen to notable highs.

    Corporate profit margins have roughly doubled from the early 1990s. In turn, that's driven cash flows and the level of cash on corporate books to the highest points in decades. And with today's historically low interest rates, that's heightened the issue of what corporate managements are doing with all that money.

    It's a big change from when Tom Huber became the portfolio manager of the Dividend Growth Fund in 2000. "No one cared about dividends then," he says. "They still remembered the high growth of the 80s and 90s."

    Corporate Cash Has Been Hitting All-Time Highs

    Over the last two decades, large-cap U.S. stocks (in the S&P 500 Index excluding financial services stocks) have been widening their average profit margins, as measured by their net income as a percentage of their sales. As a result, their average cash flows from their normal business operations as a share of their overall assets also have been rising. Despite returning more of this cash to stockholders in recent years, the average cash on their balance sheets has been hitting new highs in recent years, in absolute terms and as a percentage of assets.

    To be sure, T. Rowe Price analysts always have evaluated how well firms allocate their cash, says Brian Berghuis, manager of the Mid-Cap Growth Fund.

    "But always of most utmost importance has been the quality of company managements, their business models, and their strategies for generating cash," he says. "If there's no cash flow, there's no cash allocation issue. It's possible to get too focused on that."

    Investors Were Seeking Yield

    That happened in the U.S. large-cap market, where income-hungry investors—faced with 10-year Treasuries yielding 2% or less—have bid up the prices of higher dividend yield stocks in recent years.

    As a consequence, by the end of this year's first quarter, high-yielding stocks in the S&P 500 Index were expensive relative to the index, to dividend-growth stocks, and to the stocks of companies reducing their share counts.

    As indicated by this chart covering the decade to March 31, 2013, investors have valued differently over time companies that are high-dividend payers, high-dividend growers, and high-share-count reducers. Starting in 2011, income-seeking investors bid up the prices of shares of S&P 500 Index stocks with the highest dividend yields. As a result, their average price-to-earnings (P/E) ratio became higher than that of the average of all stocks in the index. Meanwhile, the average P/E ratio of firms most reducing their share counts with buybacks was lagging the market, and the average P/E ratio for companies growing their dividends most rapidly was about the same as that of the market.

    In Recent Years, the Market Has Rewarded Highest Dividend Yields

    Note: Highest dividend yield, fastest dividend growth, and highest-share-count reducing firms are defined as the top 20% of all firms in these metrics within the S&P 500 Index.

    But in May, U.S. stock investors—worried about rising rates—backed away, to some degree, from such higher dividend yield sectors as utilities, telecommunications, and consumer staples. But valuations remained high at the end of the second quarter.

    David Giroux, manager of the Capital Appreciation Fund, says the focus on dividends simply became too pronounced. "With the search for yield, there was a lot of crowding into names with high dividend yields, and their valuations, particularly with utility and telecom stocks, were driven to irrational extremes," he says.

    Giroux says that investors should look more for stocks of U.S. firms returning capital to shareholders in another way that can be just as favorable—companies with stable earnings growth and moderate or no dividend yields but records of reducing their share counts with buybacks.

    Apple: A Cash-Rich Company Returning More

    Apple is the most recent poster child for cash-rich companies responding to investor pressure to return more to stockholders—and for why all that glimmers here may not be gold.

    The cash piles are not evenly distributed among S&P 500 firms. The firms with the 25 largest hoards—almost half are multinational technology firms—account for half the index's total cash, T. Rowe Price research shows.

    But about a third of all the S&P 500 cash is held overseas; in Apple's case, two-thirds of its roughly $150 billion is abroad. That money cannot be used for dividends or share buybacks unless it is repatriated and subjected to U.S. taxes.

    As Josh Spencer, manager of the Global Technology Fund, puts it, "Apple's cash has been effectively trapped."

    So it was a big step when, this spring, Apple announced that it would buy back $60 billion of its stock over three years plus raise its dividend yield to 3%—altogether, a promised $100 billion allocation to stockholders.

    At the same time, the company also announced the sale of $17 billion worth of bonds—a record-sized corporate bond sale, with more such sales likely to come—to pay for the dividends and share repurchases without tapping its overseas cash.

    "Apple now is a more responsible steward of its owners' capital," Spencer says, "and that should help its valuation even as it may grow more slowly.

    Buybacks on the Rise

    Like Apple, more companies have been buying back shares of their stocks, even if the market lately has not been rewarding share-reducing firms.

    Buybacks theoretically benefit investors by their simple math: If a corporation reduces its share count by 10%, each share ought to be worth 10% more.

    Buyback activity rose before the most recent financial crisis, shrunk, and rose again as the recovery began in 2009. By contrast, dividends over the last two decades have been a more stable source of value for stockholders and, thus, are often considered the one thing that stockholders can count on.

    Moreover, managements tend to buy back their shares when their stock prices are high. "They tend to overvalue their businesses," Huber says. "They tend to repurchase when things are going well....Instead, they should be buying their stock in times of uncertainty or crisis."

    Adds Preston Athey, manager of the Small-Cap Value Fund, "The real key on stock buybacks is not whether companies do it. It's what they pay. Managements that are not financially astute can destroy shareholder value in this way faster than your dog can eat its dinner."

    But overall, buying back shares has tended to pay off, particularly relative to increasing share counts, a T. Rowe Price study has found, though it's hardly a guarantee of outperformance. "Buybacks are more tactical," says Sudhir Nanda, director of quantitative equity research for the firm. "If stockholders get a bump in values, they get it pretty quickly."

    Over the long term, however, companies that consistently grow their dividends have tended to be the best performers, he says. "If I am looking for consistent capital returns from stocks," he adds, "then it would be from companies that are growing their dividends or buying back stocks—or, perhaps best, doing both in certain years."

    Companies Could Be Returning More

    T. Rowe Price managers say companies could return a much higher percentage of their cash to stockholders, but they're often holding too much of it because of their managements' searing memories of what Athey calls their "sleepless nights" during the recent Great Recession.

    The S&P 500 dividend payout ratio—dividends divided by earnings—has risen recently from a record low of 27% in the Great Recession to more than 32% this year, according to Strategas Research Partners.

    And driven mainly by the faster pace of share buybacks, the index's total yield—from buybacks and dividends as a percentage of cash from normal operations—has rebounded from below 30% in 2009 to 42% through the first quarter of this year.

    But both the dividend payout ratio and the total yield remain relatively low. While "giving back to shareholders is higher, the fact is that corporate cash is still building up," Nanda says. "They still could do more."

    More Cash Returning to Stockholders

    CFO is cash flow from normal business operations.
    Over the last two decades, corporate cash has been shared to a greater degree with stockholders. In recent years, the main reason is that large-cap U.S. stocks (S&P 500 firms excluding financial services companies) have been spending more on buying back their own shares as a percentage of their cash flow from normal business operations (CFO). Though highly valued in recent times, dividends have not been growing as fast as a percentage of cash flow. Overall, there may be room for firms to return more: The share of their cash flow spent on buybacks is about half that of the last market peak about five years ago, and the dividend payout ratio—dividends as a percentage of net income, not shown on this chart—remains relatively low.

    Corporations of course need to retain some cash, Athey notes, for normal operations, as emergency reserves, and sometimes to present the appearance of "staying power" to their customers. In evaluating the cash on stocks' balance sheets, T. Rowe Price analysts make such allowances. And then they evaluate the potential return in value of various uses for the remainder.

    "The first thing we look at is how they generate cash," Athey says, "and the second thing is what they do with it. That's every bit as important as it has been and is getting more attention these days because so many companies clearly have more cash on their books than they need."

    As of June 30, 2013, Apple made up 13.7% of the Global Technology Fund.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.