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During the recent financial meltdown and accompanying long recession, many companies went into cash preservation mode. Not knowing if credit would be available when needed, they cut costs, sold assets, and laid off employees. A good many of them also cut back or eliminated their dividend payouts.

As a result, the nonfinancial companies in the S&P 500 built up a record hoard of around $2 trillion. Now that things don’t look quite so gloomy anymore, many are stepping back into the water. About 450 of the largest publicly traded U.S. companies increased their payouts in the first quarter. But will this continue?

A Generational Shift In Market Wisdom

Back in the days of the Internet bubble, investors largely ignored fundamental evaluation metrics such as P/Esbook value, and dividends, in favor of finding the hottest growth stocks that were going up the fastest so they could be sold a few weeks, days or even hours later. Indeed, companies that paid dividends (let alone increased them) were shunned. As the argument went, companies that gave money away were signaling to the rest of the world that they had no better use for the cash. That is, their growth days were supposedly over and it wouldn’t be long before they were put out to pasture to spend their remaining years as cash cows. 

Ironically, companies may indeed NOT have anything better to do with their cash right now. Profits are up, due to the aforementioned belt-tightening as well as modestly improved sales, and cash on hand has risen to record levels. So where should that money go? For the majority of corporations, expansion is out of the question for now. When credit was cheap and easy, many spent on buildings, equipment, and acquisitions to meet what seemed to be ever-rising demand.  Now that business has fallen off from its credit-induced peak, there’s more than enough capacity to meet normal demand growth. Also, with market prices having recovered a good portion of their losses, mergers and acquisitions aren’t as appealing as they used to be. And, again, the capacity is already in place. The third alternative, buying back shares, is also less compelling for the same reason. Now that stock prices are well off their lows from March 2009, buying shares back doesn’t quite provide the same bang for the buck. 


Hungry for Yield

The timing for a reevaluation of dividend policies appears good, as investors seeking income have been left with few attractive choices.  Money market and bank accounts currently only offer fractions of a percent in yield. And, as for Treasuries, with the recent flight to safety, many high-quality stocks now offer more alluring payouts than the U.S. government. Moreover, with bond yields so low, there’s little room for further declines and any uptick in interest rates would hurt bond values. This is no big deal if you’re holding on to maturity. But the majority of retail investors hold bonds through mutual funds rather than buying them directly, and higher yields could result in significant drops in fund prices.

Money Talks

So after two years of deep cutbacks in dividends ($58.8 billion for 2008 and 2009, combined, for the S&P 500), payouts are being raised ($12.4 billion for the year to date). But they’re still not back up to pre-recession levels, suggesting plenty of room on the upside. So who has the most cash to spare?
Notably, of the public companies with the largest cash hoards, three of the top four don’t pay any dividends. Those are Cisco Systems (CSCO - Free Analyst Report, $35 billion in cash), Google (GOOG, $24 billion), and Apple (AAPL, $23 billion).  (Note:  Cisco recently announced that it would start paying a modest dividend that would provide 1%-2% yield by the end of fiscal 2011, which ends in July.)

Among the top 100 companies in terms of cash position in the Value Line universe (all having at least $1 billion on their balance sheets), the following 12 offer the highest yields compared to 10-year Treasuries (currently around 2.7%). Also, with a nod to conservatism, all these issues carry our Highest Financial Strength rating of A++.  Johnson & Johnson (JNJ – Free Analyst Report, 3.4%), Intel  (INTC – Free Analyst Report, 3.3%), Coca-Cola (KO – Free Analyst Report, 3.0%), Chevron (CVX – Free Analyst Report, 3.5%), Abbott Labs. (ABT, 3.3%), Du Pont (DD – Free Analyst Report, 3.6%), Procter & Gamble (PG – Free Analyst Report, 3.2%), Eli Lilly (LLY, 5.3%), LockHeed Martin (LMT, 4.2%), McDonald’s (MCD – Free Analyst Report, 3.2%), Home Depot (HD – Free Analyst Report, 3.0%), and Sysco (SYY, 3.5%). It’s also worth nothing that, of these, Intel, Home Depot, McDonald’s, Sysco, and Johnson & Johnson have exhibited the highest dividend growth rates over the past 10 years, ranging (in order) from to 31% to 14%.

The Tax Man Commeth?

One overhanging issue with all this is whether Uncle Sam will be rolling up his sleeves and digging deeper into taxpayers’ pockets next year.  Of specific concern to investors will be any potential changes to rates paid out on capital gains and dividends. The Bush Administration tax cuts reduced the maximum tax on dividends to 15%. As these cuts are scheduled to expire next year, that rate could more than double to as high as 39.6%, the same as ordinary income.  But the majority of people are not in the highest bracket. And that’s one of the key issues facing Congress. The Obama Administration has indicated that it would like to maintain the tax cuts for those earning under $250,000 a year.  As it pertains to dividends and capital gains, President Obama has indicated that they might be capped at a rate of 20%. This would suggest that any overall impact would be less for the majority of investors.

Overall, while it remains to be seen if Congress chooses to maintain the tax cuts through next year, investors need to be aware that the potential impact on dividend-paying stocks could be significant. However, this sword can cut both ways. Namely, many of the aforementioned stocks (assuming dividends were reinvested) have outperformed the general market over the year to date. On the one hand, stock prices could adjust downward if a rate increase is announced, effectively maintaining the after-tax return to investors. Likewise, expectations of an increase could already be priced into current market values, suggesting some potential upside if the revision is smaller than expected. Also on the positive side, there’s the possibility that some companies will choose to pay a one-time special dividend before any announced tax changes take effect.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.