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11/22/2002
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Taking Stock: Cisco Investors Miss Out On Dividend Vote

Disciplined use of capital translates into higher total returns.

At last week's shareholder meeting for Cisco Systems, one of the biggest proposals was the recommendation to issue a dividend for the first time in the company's history. The proposal not only lost, it was crushed. Why didn't Cisco shareholders like the idea of getting some money back when the company has $21.5 billion in cash, and they're earning very little?

There are some simplistic answers: The board of directors recommended voting against the shareholder initiative, and since the board was re-elected by a 95% mandate of the voting shareholders, it isn't too surprising that its recommendations would be followed. John Chambers, the popular CEO, has often stated that he would prefer seeing the company buy back stock or make acquisitions. This alone would make many shareholders vote against the proposition. And let's not forget that part of this argument against paying dividends is that they are taxed twice--once at the corporate level and then a second time at the shareholder level. This may change with the upcoming shift in Congress, as legislation may eliminate double taxation on corporate dividends, but I wouldn't hold my breath.

Here's why shareholders may have made the wrong call. First, studies show that publicly traded companies that pay dividends are more disciplined about how they use their capital. Ultimately, this translates into higher total returns to shareholders (dividend plus share-price appreciation). For the Standard & Poor's 500, the compounded annual growth rate with dividends reinvested from 1926 through 2001 was 10.7%. Without dividends, the rate was 6.1%. In other words, 43% of the S&P 500 total return for the long-term period was generated from dividends. Even if you look at the recent bull market run, when the compound annual growth rate was higher, the growth rate with dividends was 15.9% between 1995 and 2001 and only 14% with capital appreciation. Including 2002, the spread further favors dividends, so dividends aren't such a bad play in a volatile market.

Second, many larger institutions and mutual funds can't buy stocks that don't pay some sort of dividend, no matter how small. Paying a dividend will increase the potential investor base and diversify shareholders, enhancing liquidity and perhaps reducing volatility. Higher liquidity and lower volatility reduce shareholder risk and help to reduce the cost of capital.

Third, Cisco's fundamental business is uncertain and volatile, and it has become even more so as the company targets the telecom industry. Therefore, it isn't always clear that Cisco will make the best investments, given its size. Since cash on the balance sheet earns very little, companies eventually must invest in their business to generate higher returns on equity. The company is committed to buying back $8 billion of its own shares, of which $3 billion has been spent this year. This will reduce share count, but it isn't clear that share repurchases are always made at a discount to fair value. It's possible the company may overpay for the shares it repurchases.

Companies get rewarded for capital discipline, and part of that discipline is making sure shareholders get paid back over time. One of the best ways to do that historically is to pay a dividend back to shareholders. Maybe they'll get it right next year.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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