By JACK HOUGH
Plenty more companies may follow suit ahead of a potential dividend tax hike next year. But investors shouldn't expect all of those announcements to result in share-price gains.
Dividends are cash payments companies use to return a portion of their profits to stockholders. More than 80% of large U.S. companies pay regular dividends, and at one time, it was common for companies to supplement these dividends during good years with special, one-time payments. In 1950, for example, nearly half of regular dividend payers issued special payments.
Last year, less than 1% of companies paid special dividends. But there may be a year-end rush of announcements, for three reasons. First, U.S. companies are stuffed with spare cash. Second, spending on regular dividends looks modest relative to yearly profits. Third, a temporary dividend tax cut that took effect in 2001 and got a two-year extension in 2011 is poised to expire at the end of this year. Currently capped at 15%, dividend taxes could top out at 39.6% next year -- barring action by Congress -- plus an additional 3.8% health care tax on investment income, for a total dividend tax rate of 43.4% for wealthy investors and high earners.
In other words, companies may be able to reduce stockholder taxes by giving them an advance on future dividends.
The bulk of special dividends are usually paid in November and December. In 2010, when the threat of a dividend tax hike last loomed, 281 companies made payments during those two months, up 37% from the year before.
Companies that are candidates for special dividends include those that have plenty of cash (after subtracting for debt) relative to their stock market values and operating needs. For example, Cisco (CSCO),
Among these, Cisco recently increased its dividend payment. Dell and Forest Labs pay no regular dividend. Microsoft made a special dividend payment in 2004 equal to more than 10% of its stock price.
Google isn't far behind, with net cash equal to 18% of its stock market value.
But investors shouldn't buy stocks based solely on potential for special dividends. The payments themselves don't add to returns dollar-for-dollar, because stock prices are reduced to offset them. If dividend-paying stocks outperform over the long term (and there's evidence they do), it's because the payments impose spending discipline on managers. Companies that have to meet quarterly cash payments may be less likely to spend on squanderous acquisitions.
It's not clear that special dividends have the same effect. A study published in 2009 in the Quarterly Review of Economics and Finance found that special dividends between 1926 and 2001 had no effect on returns following the announcement dates.
Also, companies that are candidates for special dividends are also candidates for share repurchases -- another means of returning cash to investors, and one that doesn't trigger a tax.
In AOL's case, the stock jump suggests investors approve of the company's decision to return cash to stockholders. The same might be true for other companies that announce special payments this year, but the prudent move for investors is to stick with shares of companies that have attractive regular dividends and plenty of potential for long-term dividend growth, regardless of the possibility of a special dividend. (See "Finding the Next Dividend-Paying Stars").
Among the companies mentioned above, that includes Microsoft, which yields 2.6%; Cisco, 2.9%; and Analog Devices, 3.0%.