Tag Archives: Dividends

Dividends (l): the return of the cash dividend

November 18, 2009 By in Basic Concepts, Current Market Thoughts, Dividends Tags: , , , , , Leave a comment

How dividends come to be

Company managements are stewards of the capital that the company owners, the shareholders, have placed in their hands.  One of the jobs of management is to decide what to do with the cash the business generates.

There are two main choices:

–reinvest the money in the business if profitable opportunities to do so can be identified, or

–return the money to shareholders.

The return typically takes two forms:

–periodic payment of cash dividends to shareholders, or

–stock buybacks (a more dubious alternative, in my opinion).

“double taxation”

In many countries, including the US, cash dividends are subject to what is called “double taxation,” meaning that although the dividend is paid out of the money that’s already been taxed at the corporate level, the recipient is also required to pay income tax on the amount received.

Corporate managements in recent years have preferred to have stock buybacks rather than cash dividends, citing the avoidance of double taxation as a reason.  I find this a bit disingenuous.  Many times, companies use the buybacks to soak up (and obscure the negative effect on ordinary shareholders of) new stock being issued to managers through stock option programs.   If you watch the money trail, the cash leaves the corporate treasury and winds up in the pockets of corporate executives.

Forty-somethings could care less about dividends

For the past twenty years or so, investors in the US have have worked up virtually no interest in stocks for their dividend-paying ability.   How so?  The Baby Boom was (relatively) young and interested in making its money grow fast, that is, in capital gains.  The coupon on government bonds was over 7% until the internet bust, and interest rates were steadily falling as the Fed drove inflation out of the economy.  So T-bonds were the natural alternative for individuals desiring income, offering high yield as well as the chance of capital appreciation.

In part because of this, stocks of companies whose main virtue was the ability to generate steady income fell to low price levels.  Many were taken out of the public equity market–first, in a wave of junk bond-related acquisitions, and more recently by private equity.

Now, fast forward to the present.

For retirees, it’s a different situation

The Baby Boom is reaching retirement age and starting to shift its investment preferences toward income generation rather than making its capital grow.  Long-dated government bonds are yielding half what they were ten years ago, and have in them the potential for capital loss as/when interest rates begin to rise from the current crisis-low levels.  Money market funds yield close to zero.

For the stock market, too

On the other hand, many integrated oil companies, utilities and telecom firms have stocks that yield about as much as the 30-year T-bond.  In some cases, the yield is higher–but that’s not necessarily a good thing (more about this in my next post).  In addition, many well-known large-cap leading lights, like WMT (2.0%), XOM (2.2%), INTC (3.1%) and MSFT (1.7%) have respectable dividend yields.

Individuals are still mostly oblivious…

I don’t see overwhelming evidence that individual investors have picked up on the attractiveness of dividend-paying stocks yet.  They see their investment issue, but not the solution.  In fact, I pointed out in a post in late February that some basic dividend-related investment concepts, like yield support (the idea that at some point high dividend yields would stop stocks from falling further), seemed to have faded from the market’s memory.

..but maybe not for long

That inattention may not last long.  It seems to me that financially and operationally sound companies have begun to signal their health by raising their dividends.  XOM and WMT did so near the bottom of the market.  INTC has just followed suit.  MSFT, which has shown a pattern of raising its payout in December, may be the next market titan to follow.  WYNN (which I own), a much smaller firm, has just made a very strong statement about its financial health by declaring a $4 a share (about 6%) special dividend to be paid next month, plus the initiation of a regular 20¢/quarter dividend.  Of course, part of the WYNN statement comes from the fact that its bankers have allowed the payouts to happen.  Sooner or later, the market is bound to notice.

In fact, Wall Street may already be taking heed.  Another, more subtle, indicator of the market’s attitude toward dividends is to examine what happens on the day a stock begins to trade ex dividend, i.e. the first day when buyers are not entitled to receive an upcoming payment.   Does the stock in question decline by the amount of the dividend, or more?  That’s bad.  Or does it “carry” some or all of the payout, i.e. not decline at all or decline by less than the dividend.  Tis is typically a strong sign of approval.

WYNN is a case in point.  It paid out $4 a share, but declined by $1.52 in a more or less flat market.  So it “carried” $2.48.  I interpret this as meaning that investors are not as unaware of dividend events as they were in February.  (Now, it may be that investors missed the fact of the payout completely, thought the bottom had dropped out of the stock at the open and stepped in to grab a “bargain.”  That would mean the stock’s rise would be a sign of ignorance, not approval.   Maybe so, but I’ve always found it a dangerous to underestimate the collective intelligence of the market.  Yes, LVS and MGM rose, too, but their financial conditions are so more precarious that I’m not sure they’re comparable.)

Naturally, the earlier we are in recognizing a trend toward buying dividend-paying stocks, the better it is for us–as long as somebody else follows.

That’s it for today.  In my next post, I’ll write about how companies decide on a dividend increase–because you want steady and rising income, and where to look for assurance the dividend is secure.

Dividend Discount Model

May 1, 2009 By in Academic Theories, Basic Concepts, Dividend Discount Model Tags: , , , , , 1 Comment

The dividend discount model (DDM), a variation on the idea of present value, is one of the older methods for evaluating a stock.  It is sometimes called the Gordon model, after Myron Gordon, an academic who wrote about it in 1959.

The two main ideas behind the DDM are:

1.  a stock is a funny kind of bond and so can be valued more or less the same way one would a bond (an idea that hearkens back to the day when the stock market was the exclusive province of coupon-clipping descendants of industrial tycoons); and

2. by far the most important thing to an investor is the dividends he receives, so they, not the company’s profits, should be what is evaluated.

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Shaping a Portfolio–Dividend-paying Stocks

April 17, 2009 By in Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , Leave a comment

A Traditional Way of Allocating Assets

One traditional technique for individual investors to allocate assets is to establish a cash reserve and then allocate enough money to government bonds or other fixed income that interest payments will cover living expenses.  Any remaining money would go into riskier assets, like stocks.

The idea is that the bonds provide a reliable, regular stream of income.  They are subject to two risks, though, assuming you hold to maturity: inflation may erode the purchasing power of interest and principal; and the principal must be reinvested at the end of the term of the bonds.  The stocks, on the other hand, may not provide much income but, because they are ownership interests in corporations strong enough to be publicly traded, they provide superior growth potential as well as some protection against inflation.

How Today Differs

Today, for the first time since the Great Depression and the years immediately after World War II, we are in the unusual position that stocks provide pretty much the same income as government bonds.  Even after the market advance since the early-March lows, and factoring in the dividend cuts by financial companies, the dividend yield on the S&P 500 is still about 2.5%.  If we consider only dividend-paying stocks in the S&P 500, the average yield is about 3.25%.  This compares with the 10-year Treasury bond, which yields 2.87% and the 30-year, which yields about 3.75%.

Unlike bond interest, there is the possibility that dividend payments can rise.  And because the Fed has responded to a horrible economy by temporarily lowering short-term rates to effectively zero, we are arguably at a high point for fixed income.  This, at a time when we are also, arguably, at a low point for stocks.

Unlike a few weeks ago, it may not be possible today to match the yield on the 30-year bond without reaching into the riskiest end of hte S&P 500.  But stocks like MMM, PG or INTC all yield about 3.5%, well above the 10-year bond.  Yes, these are mature companies that may not produce sizzling capital gains.  But if the dividends are secure, they seem to me to be a better choice than treasuries.

What about corporate bonds instead?  Yields here are much higher than treasuries.  (Remember, in reading what follows, that I’m a stock person, not a bond person).  Yes, that’s true and there is also some overlap between the riskiest end of the S&P 500 and investment-grade corporate issuers.  But I think the overall riskiness of the issuers of corporate debt, especially below investment grade (“junk” or “high-yield”), is substantially higher than for the S&P, and the instruments are substantially less liquid.  So you really better know what you’re doing in this arena.

What Could Go Wrong

What do I think could go wrong with buying 3.5%-4% dividend yield stocks?  Three points:

1.  The worst case is that operating weakness may force the company to reduce, or even eliminate, the dividend.  Dividends are supposed to be paid out of profits.  Also, the money may be needed to repay debt or to fund the operation of the business.  But you can do homework to see if this is a reasonable possibility.  Analyzing the flow of funds is the best approach.  But you can also check with services like Value Line for their statistics on how well covered the dividend is.  By the way, this is the issue with ultra-high dividends–the market is saying it doesn’t believe the payout is sustainable.

2.  The total return on a higher-than-average dividend stock may be below that of the market.  If we assume there’s no free lunch, then there’s a price to be paid for straying from the combination of dividend and cpaital change that the index is presently offering.  For the first extra unit of dividend, you may have to only give up one unit of chapital appreciation.  For the second, you may have to give up 1.2 units, and so on.  This may not matter to you.  But what I think is the most interesting aspect of today;s situation is that you don’t drift far from the market yield to do better than a 10-year bond.

3.  This one is a little bit out of left field.  I’m not sure how serious a worry it is.  As I’ve written elsewhere, it’s been more than twenty years since dividends have been close to 3% on the S&P 500 (this may be another way of saying it’s been that long since stocks have been so weak).  In any event, having a large dividend yield hasn’t seemed to me to have provided any cushion at all against a stock’s fall.  That could be changing, on the way back up.  But if company directors get it into their heads that dividends are a stock attribute that investors don’t want, sort of like huge tail fins on a car, then they may begin to think the payout could be better used by the company elsewhere and cut the dividend even though they don’t need to.

What Ever Happened To Yield Support?

February 26, 2009 By in Stock ideas Tags: , , , , , 1 Comment

What is yield support?

It’s a notion that was prevalent in the Eighties and earlier, back when the S&P had a long history of significant nominal dividend yield.  The idea is that, in a downturn, the fall in the market as a whole–and in dividend-paying stocks in particular–will be cushioned by the fact of continuing dividend income.  At some point, the argument goes, a 4%-5% dividend yield means “you’re being paid to wait” for earnings to recover.  This current income means you can buy the stock sooner, and at a higher price, than you would without the dividend.  Therefore, the price never gets to the level of the most bearish prediction.

In the old days dividends were important enough as a component of total return that a famous Wall Street strategist sounded a stern warning in the mid-Eighties that the stock market was about to collapse.  His reason?–the dividend yield on the market had broken below 3%.  He had charts showing that this had occurred only a few times in the post-WWII era, and then only for short periods.  Every time, the market had soon entered a severe correction.

Unfortunately for this prediction, and for this guy’s career as a strategist, the stock market powered ahead from that point for fifteen more years.  The dividend yield on the S&P steadily declined to around 1%, returning to the 3% level only during the 2008 market decline .

What went wrong?  What didn’t he see?  I think the most important factors were:

* investor preferences changed.  Baby Boomers wanted capital gains, not dividend income.

* this allowed younger, more capital-hungry companies (who wouldn’t pay any dividends) to list, changing the composition of the market.

* disinflation raised the real value of even a static nominal dividend (the story of consumer staples and utilities in the Eighties).

“Paid to wait” is the operative phrase now

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