For the last twenty-five years, dividends have played virtually no role in the thinking of most equity portfolio managers in the United States.
For one thing, the quarter century has been a time of great and rapid technological change–and has therefore presented unusually good investment opportunities. So there was no need for dutiful managements to return profits to shareholders for lack of lucrative reinvestment possibilities.
For another, increasing affluence and the rise of discount brokerage meant stocks were becoming accessible to most adults, not just coupon-clipping tycoons. Baby Boomers were just coming of age and looked to stocks for capital gains. Boomers simply weren’t interest in dividends then.
The Baby Boom is nearing retirement. Age-appropriately, Boomers have begun to shade their investment choices away from pure capital gain toward vehicles that mix in an element of income as well. At the same time, the domestic economy has matured. Even before the financial crisis, economic growth had begun a secular slowdown. In addition, the corporate field has become much more crowded with competition from Asia and Latin America.
As a result of both these developments, many American corporations are beginning to pay significant dividends again.
Three interconnected reasons:
1. The last market cycles in the US where dividends made a real difference were during the accelerating inflation of the late Seventies (dividends were a bad thing) and the early disinflation years of the Eighties (dividends were very good). Most of the portfolio managers who actually worked in these periods have either retired or are senior executives no longer managing money.
2. Portfolio management is a craft skill. You learn by practical experience as the apprentice of a skilled practitioner who is willing to teach, or at least willing to let you observe what he/she does. Dividends just haven’t come up as a key topic in the training program for a very long time, so (I think) managers under fifty years of age have little clue about how to react to the change in investor preferences I think is going on currently.
3. Academic finance, surprisingly, has (for a change) some useful information. But it’s not very much. So you won’t learn about dividends there. It’s unusual to see a faculty member with any practical knowledge of experience as a professional investor. It’s rarer still to see a securities analyst of portfolio manager with tenure. The best analogy I can come up with is that if you want to be a creative writer you don’t learn how by studying to be a literary critic. But even that’s not quite right, since the literary critic and the writer share common assumptions about the value of the written word. Finance academics deny that portfolio management is possible.
the Jeremy Siegel op ed article in the Wall Street Journal
I’ve written about this column in an earlier post. In it. Mr. Siegel, a professor at UPenn, suggests that dividend-paying stocks can be a viable alternative to bonds.
I think the observation is correct and should be relatively uncontroversial. Of course, I’ve been writing the same thing for months. But the Siegel article has generated a mini-firestorm of protest and it has spawned a number of pronouncements “correcting” what the authors consider Mr. Siegel’s misconceptions.
I’ve been fascinated–maybe stunned is a better word–by the counter-articles, which seem to me to reveal the authors’ ground level lack of understanding of what dividends are all about. I’ve gone back and forth in my mind about whether to link to some examples and have decided, for good or ill, not to. But careful readers of the Financial Times will have seen a particularly egregious example of what I’m talking about–a rare reversal of form between the FT and the WSJ.
So I decided I’d put down what I consider some of the fundamentals about dividends.
1. From a credit analysis perspective, common equity dividends (I’m going to ignore preferreds in this post) are riskier than interest payments on the same company’s bonds. If a firm gets into financial trouble, it can much more easily decrease of eliminate dividends to shareholders than it can interest payments to bondholders.
2. Most bonds have a specified term, usually ten years or less. Although the bonds may be far less liquid on a day-to-day basis than stocks, the bondholder will–absent financial problems with the bond issuer–receive his principal back at the end of the term. Generally speaking, equities have no similar feature. You may receive more than your original investment if/when you sell, depending on market conditions at the time.
3. In theory, any company is continually looking for high return projects to reinvest the cash its business is currently generating. If it can find such projects, it spends its cash on them. If not, however, rather than invest in projects where it thinks prospects are at best mediocre or let lots of idle cash build up on the balance sheet, the company should return funds to the shareholders (the legal owners of the company) for them to reinvest elsewhere.
As a practical matter, companies don’t always do this. Sometimes, shareholders may make it clear to management that they don’t want the money back, that they’re rather have management reinvest even in cases where the returns may not be so high. Most often, however, CEOs’ egos get in the way of doing the right thing by admitting that industry growth is slowing and that harvesting an investment is more appropriate than sinking new money in.
4. Dividends are paid out of profits. Typically, as income rises so too do dividends–unlike the case with bonds, whose coupon payments are typically fixed.
5. Dividend levels are set by a firm’s board of directors. In well-managed companies, dividends are always backward-looking. That is, they are set without consideration of possible future profit growth, but only at a level that historical experience says is appropriate. Dividend increases are only made where there is strong evidence the business will be able to maintain the new payout even in weak economic times.
6. Although dividend payout ratios are usually expressed as a percentage of profits, I’ve always found the correlation with cash flow to be stronger.
7. Managements have different levels of skill in the dividend setting process, as well as different levels of commitment to maintaining the dividend during lean times. As a general rule, firms that have cut the dividend in the past are more prone to do so in the future.
8. The highest current yield isn’t always the best. It may simply be signalling the market’s belief that the dividend has no chance of growing–or, worse still, that the current payout is likely to be reduced.
9. Dividend growth prospects count, too. To my mind, the ideal combination is a stock
–with, say, a 2.5% yield but which is
–a leading firm in a maturing industry, and
–where management recognizes its obligation to shareholders not to continue to expand rapidly but rather to return an increasing amount of the cash it generates to shareholders.
Remember the rule of 72: a 10% annual grower doubles cash generation every seven years. A 15% grower does this in less than five. In a firm like I’m describing, dividends have a chance to grow faster than that. In the latter case–admittedly not an everyday find–dividend payments ten years from now would be 4x+ the current level, meaning a 10% dividend yield on an unchanged stock price.