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If You Want Earnings Quality, Look for Dividends

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Last column, Marc discussed Dividend Champions. Today, he goes over why raising the dividend is so important.

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Editor's note: The following is an excerpt from Get Rich With Dividends.

When companies report their quarterly earnings results, the language they use is couched in legal-speak and cautionary statements. Companies never want to set expectations too high because when they fail to meet those prospects, the stocks get punished.

Additionally, when things are not going great, management will try to use more optimistic language in order to dilute the bad news. But a raised dividend says more than a CEO can ever state.

Generally speaking, it says: We have enough cash to pay shareholders a higher dividend and we expect to generate more cash to continue to sustain a growing dividend.

As economists Merton Miller and Franco Modigliani pointed out, when "a firm has adopted a policy of dividend stabilization with a long-established and generally appreciated 'target payout ratio,' investors are likely to (and have good reason to) interpret a change in the dividend rate as a change in management views of future profit prospects for the firm." They were the first economists to suggest that dividend policy is an indication of executives' beliefs on the prospects of their companies.

The University of Chicago's Douglas J. Skinner and Harvard University's Eugene F. Soltes agree, writing: "We find that the reported earnings of dividend-paying firms are more persistent than those of other firms and that this relation is remarkably stable over time. We also find that dividend payers are less likely to report losses and those losses that they do report tend to be transitory losses driven by special items."

In the same paper, the two professors concur with the earlier statements that stock buybacks do not convey the same confidence as dividends because they represent "less of a commitment than dividends."

Especially for companies with track records of five years or more of raising dividends, the higher dividend not only delivers a higher income stream to shareholders, it sends a clear message that the policy of raising dividends is intact and should be for the foreseeable future.

A higher dividend is certainly not a guarantee that the dividend will get a boost next year. But it is a good indication that management is serious about the policy and will likely work to ensure it can be maintained.

The growth in the dividend is especially noteworthy during a disappointing earnings period. As I mentioned, when a company misses earnings expectations, investors sometimes panic, which can lead to management getting unnerved and making drastic decisions such as layoffs and restructurings.

But when earnings are not so hot and the company still raises the dividend, the message is that things are not so bad. It's as if management is telling you, "There is still plenty of cash on the books and it's likely that we'll generate enough cash next year to raise the dividend again."

For an investor looking at the big picture, that's a powerful message. The chatter may be about the near-term disappointment, but the shareholder who's in it for the long haul and understands that businesses go through cycles of ups and downs sees that the company's strategy is intact and should be able to weather the storm.

The market gets this message loud and clear. Companies that raise dividends year after year tend to outperform the market. As I describe [in my book], Perpetual Dividend Raisers historically outperform the market.

And keep in mind that most of the Perpetual Dividend Raisers are what you might describe as stodgy old companies. They aren't high-growth tech companies that will benefit from some hot new technology or trend.

The market clearly appreciates the fact that these companies are strong enough to raise their dividend payment every year.

Marc is the Associate Investment Director of the Oxford Club and the author of Get Rich with Dividends: A Proven System for Earning Double-Digit Returns.
No positions in stocks mentioned.
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