A Different Way to Do Dividends

Most dividend-paying companies in the U.S. follow the same formula: fixed quarterly distributions, most often raised or maintained once a year. Many investors have come to expect annual dividend increases regardless of how the underlying business performs, and companies often bend over backward to comply. The sudden interruption to business as normal caused by the coronavirus outbreak has many of those best-laid plans going awry. Companies left and right have been suspending their dividends, or interrupting streaks of increasing payouts. And investors are clearly worried that more dividend cuts are in store. Russell 1000 stocks that sported at least a 3% yield at the start of 2020 have lagged behind the non-dividend paying companies in the index by 18 percentage points year to date. Many management teams are being forced to quickly prioritize saving cash over everything else as long as physical distancing requirements remain in place. But a stock's dividend is often seen as sacrosanct, with boards choosing to suspend buybacks, slash capital expenditures, and furlough staff before touching the payout. Some companies are even willing to take on debt to cover dividend commitments greater than their operating earnings. Goldman Sachs' Steven Kron and James Covello suggest a different way of doing things: variable dividend payouts that flex alongside a company's performance. In good years, the dividend may rise, while in bad years it automatically falls as far as business declines. "We understand that there are arguments against such an approach—most notably the disruption of the social contract that exists between  companies and dividend-seeking investors," Kron and Covello write. "That said, we think the long term benefits outweigh the near-term 'costs' and believe as companies cut or temporarily suspend dividends, the current environment presents an opportunity to consider a different approach upon their resumption." They propose several possible alternatives to fixed dividends, including a payout pegged to operating metrics, such as 60% of free cash flow. They also put forward rules for share buybacks, such as automatically reducing repurchases when the share price is above previous year averages. That could help avoid wasting cash on an overvalued stock, possibly right before a crash when saving cash will be especially required. Kron and Covello acknowledge that if adopted, their proposals could result in overall less cash returned to shareholders. But if more cash does remain on a  balance sheet and the company avoids taking on new debt, they note that investors could reward its lower-risk stock with a higher valuation multiple. What do you think? Is a company breaking its understanding with its investors by paying anything other than a steady and predictable dividend? Or would tying payouts directly to operating performance be an attractive alternative? Just reply to this email.