Monday, April 18, 2011

Jam Today or Jam Tomorrow?

By Weston Wellington

Until recently, twenty-nine of the thirty constituents of the Dow Jones Industrial Average paid regular cash dividends to shareholders (Disney makes a single annual disbursement while the others distribute on a quarterly basis). Cisco Systems Inc. of San Jose, California, was the lone holdout, having never paid a dividend in its twenty-one-year life as a public company.

Cisco was founded in 1984 by a husband-and-wife team of computer scientists who were frustrated by their inability to communicate by email between separate buildings on campus. A device to allow different computer networks to share information was the firm's initial product. The company hired its first employee in 1986, held its first staff picnic in 1989, and sold shares to the public for the first time in February 1990, having recorded $27 million in revenue the previous year. Today the firm has over 70,000 employees and over $40 billion in annual revenue.

Last month the company announced its first cash dividend, with a disbursement of $0.06 per share to holders of record as of March 29, 2011. Cisco's stock price at the time of the announcement was $17.14, which works out to a projected annualized yield of 1.4%.

Although this news received little attention, we think it is worthy of reflection since it illustrates a key principal of a free market economy. Entrepreneurs come to the capital markets with business ventures in need of funding. Investors supply equity capital to those ventures in return for a share of the profits. Risky ventures with little prospect of an immediate payoff must offer the possibility of a large future reward as an inducement for investors to fund such projects. For Cisco shareholders, how long was the wait and how big was the payoff?

The investor who purchased 100 shares of Cisco at the initial offering price of $18 in 1990 received no cash return from the enterprise over the subsequent twenty years. But the 6-cent initial dividend will provide that same shareholder with a cash return of $1,728 per quarter or a projected $6,912 per year. Relative to the initial investment of $1,800, the annual cash return for the initial Cisco investor is 384%. As financial theory would suggest, Cisco's stock price has factored in this dividend-generation ability, which explains why the original 100 shares (now 28,800 shares after 9 stock splits) have a current market value of $508,320.

Suppose we had limited our eligible investment universe over the past twenty years to firms paying cash dividends. We would have excluded Cisco Systems, Kohl's department stores, software developer Oracle Corp., heart-valve maker St. Jude Medical, Starbucks coffee shops, and many others. We would have included dividend payers such as photography giant Eastman Kodak, discount retailer Kmart, and auto parts maker Dana Corp. We might have drawn comfort in the knowledge that all three of the latter group had paid dividends for many years (Dana since 1936, Kmart since 1913, and Kodak since 1902) and had been singled out for special praise by the authors of a widely read management book, _In Search of Excellence. _Alas, a successful past offers no assurance of a prosperous future; Kmart and Dana subsequently filed for bankruptcy, while Kodak shareholders have seen their cash dividends eliminated in 2009 and the share price shrivel by over 90% since year-end 1990.

The five firms presented in the table below have all recently initiated cash dividends after many years as a public entity. Clearly, this list represents some degree of selection bias: If we could predict which of today's new ventures will survive for the next twenty years and begin paying dividends, our success rate in identifying huge winners would be greatly enhanced.

The moral of the story? We should not use this exercise as a motivation to identify the next Cisco Systems or St. Jude Medical. But when we exclude firms from our portfolio that pay no dividends today, we may deprive ourselves of the returns associated with the biggest dividend generators of tomorrow. A broadly diversified strategy that includes both dividend payers and non-dividend payers will ensure we enjoy the potential rewards of both.

Current market value and indicated annual income associated with purchase of 100 shares at initial public offering price

CompanyIPO DateIPO PricePrice
Cisco (CSCO)02/16/90$18.00$17.6528,800$508,320
Kohl's (KSS)05/19/92$14.00$54.20800$43,360
Oracle (ORCL)03/12/86$15.00$33.5432,400$1,086,696
St. Jude Medical (STJ)02/09/77$3.50$52.2619,200$1,003,392
Starbucks (SBUX)06/26/92$17.00$35.773,200$114,464
CompanyInitial DividendDividend RateAnnual IncomeYield on
Purchase Price
Cisco (CSCO)03/29/11$0.06/qtr.$6,912384%
Kohl's (KSS)03/07/11$0.25/qtr.$80057%
Oracle (ORCL)06/12/10$0.06/qtr.$7,776518%
St. Jude Medical (STJ)03/29/11$0.21/qtr.$16,1284,608%
Starbucks (SBUX)08/02/10$0.13/qtr.$1,66498%

Thomas J. Peters and Robert H. Waterman Jr., In Search of Excellence—Lessons from America's Best-Run Companies (Harper & Row, New York, 1982).

Google Finance, (accessed April 8, 2011).

Yahoo! Finance, (accessed April 8, 2011).

Cisco Systems Inc., (accessed April 8, 2011).

St. Jude Medical, (accessed April 8, 2011).

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