Tag Archives: Dividends

Dividend-paying stocks: some choices are better than others

September 21, 2010 By in Constructing a Portfolio, Dividends, Portfolio management, Strategy Tags: , , , , , , , , , Leave a comment

general

One basic criterion for buying a security is how that issue fits into an investor’s overall investment plan–that is, how it helps meet his goals and objectives, whether it falls within his risk tolerances, and whether he is willing to expend the time and effort needed to research and monitor the position.  (This third aspect is, in my opinion, the one that investors most commonly overlook.)

Looking at dividend-paying stocks, I think the main conceptual issue is the possible tradeoff between getting the highest current income and getting the best total return.  You may not be able to do both.  If your primary need is to generate, say, a 4% current yield from the US stocks you hold,  you can probably do that, but chances are that you’ll underperform the S&P 500.

That shouldn’t be a big deal, since your aim is to produce steady income, not generate capital gains.  It only becomes one if you forget–or don’t understand in the first place–what your primary goal is.

Why should an income-oriented strategy underperform?

In theory at least, prevailing prices express the aggregate market preferences for dividend yield and potential capital appreciation.  In the US at present, this preferences are for a 2% dividend yield and a forward PE of about 12 .  To tilt my personal portfolio away from the market by a little bit, by trading some capital appreciation potential for extra current income, I should not have to give away much more than I receive.  But as I try to trade more and more appreciation for income, other participants in the market become increasingly reluctant to accommodate me, since doing so would move them farther away from their desired portfolio mix.  So I have to “sweeten” any deal by offering increasing amounts of capital appreciation to get an extra unit of dividend income.  Therefore, I start to underperform.

That’s the argument, anyway.

By the way,  I think in today’s market it may be possible for an income-oriented strategy may do better than one might think.  Several reasons:

–I imagine the movement of investors reaching for yield by moving from one part of the fixed income market to another as being kind of like the tide coming in.  First it was government bonds, then corporate debt , then junk, now gimmicky things like century bonds.  The wave hasn’t hit the equity market yet.  But maybe it will.

–dividend haven’t been important in the US stock market for twenty-five years.  Arguably, if/when the wave hits equityland, it’s not going to be as efficient as it might be.

–as far as I can see, there isn’t very much good research information about dividend-paying stocks around.

If so, great.  It would be icing on the cake—but not by itself a compelling reason to concentrate on dividend-paying stocks.

how I’m choosing

In today’s US markets:

the two-year Treasury yields 0.46%

the ten-year Treasury yields 2.7%

the thirty-year Treasury yields 3.9%

the S&P 500 yields 2%

the forward market PE is about 12, meaning an earnings yield of 8%.

a first step

Over the past thirty years, the dividend yield on the entire stock market has only been higher than the coupon on the long bond during periods of extreme market stress–and even then only for brief periods of time.  March 2003 and March 2009 were the only two instances over the past decade.

We’re obviously not in that position today.  But still, in a less than 4% long bond world, there’s got to be some point beyond which a high dividend yield is an indicator of potential trouble–of potential investor worry that the dividend can’t/won’t be maintained at the current level.

Let’s say that point is a 6% dividend yield–above which one must tread very carefully.  As a matter of stock triage, unless you are willing to spend the time doing careful research you may want to discard these high yielders as too good to be true (although as you’ll see below, they may merely be stocks with little hope of capital appreciation).

three cases

Let’s work out three simple examples to try to distinguish among the various types of dividend-paying stocks that are available in today’s market.  They are:

1.  an 8% dividend yield, no earnings per share growth

2.  4% yield, 5% average annual eps growth

3.  2.5% yield, 15% annual eps growth.

We’ll take a five-year investment horizon and assume that all of the stocks pay a constant percentage of profits in dividends and that none enjoy PE expansion or suffer PE contraction.  To make the arithmetic easier, let’s also say that the initial price of each issue is $100.

Stock #1:  at the end of five years, the stock price remains $100.  The owner has received $40 in dividends.  The stock yields 8% on the $100 purchase price.

Stock #2.  The fifth-year stock price is $$127.70.  The owner has received $21.83 in dividends.  The stock yields 5.1% on the $100 purchase price.

Stock #3.  The terminal stock price is $200.  The owner has collected $16.88 in dividends.  The stock yields 5% on the $100 purchase price.

the differences–objectives matter

Stock #1 generates by far the most income.  Even the fast-growing #3 will not be matching #1 on a current payout basis for close to another five years.  #2 won’t be doing so for at least a decade.

On a total return basis, #1 and #2 are within striking distance of one another.

Stock #3 is the total return winner.  It does so on the basis of its capital gain, which, in turn, rests on its ability to generate above-average growth for an extended period of time.  It produces only a third of the income of #1.  A #3 also takes a lot more careful monitoring.

My investment personality orients me toward #3, but then I’m content to wait five years for serious income to start to kick in.  But I also own one or two #3 types, understanding that they may underperform, because of the income they produce.

risks

There are specific risks associated with every stock.

For these general sketches, it seems to me that the risk in #1 is that the company cuts the dividend, either because it can no longer afford to pay at that high level or because management decides to use the money that would otherwise be returned to shareholders in an effort (usually futile) to expand.

For #3, the risk is that the company can’t sustain a 15% growth rate for longer than a few years.  As its business matures, it may turn into a #2.  As it does so, its PE would likely contract.  This means capital appreciation will be lower than the simple projection above anticipates.

who are they?

Do instances of these three general forms exist?  Yes.

#1s are probably European banks or telecoms.

#2s are gas or electric utilities.

#3s are harder to find.  They’re maybe TIF, or WMT, or maybe even INTC.



Exotic turns in the quest for yield

September 20, 2010 By in Current Market Thoughts, Preferred Stock, Recent Market Action, Stock ideas Tags: , , , , , , , , , , 1 Comment

bond yields are paltry

The yield on the ten-year US Treasury bond is 2.74%.  The yield on the thirty-year Treasury is 3.9%.  The two-year note yields 0.46%.  In shorter-term instruments, your capital is safeguarded but you receive basically no income.

We know that income-oriented investors, both individuals and institutions, have been forced to search for yield elsewhere.  Year to date, the dollar value of new junk bond issues in the US has already surpassed the total for all of 2009–which itself was a record year for issuance.  High yield bond prices have already returned to the levels of mid-2007, before the financial crisis began to take its toll on valuations.  True, yield spread over Treasuries is more than 300 basis points wider today than then, but the two-year note was yielding about 4.9% during the summer three years ago (how quickly we forget!).

New issuance appears to be accelerating.

exotic alternatives

Two new, more exotic types of issue have begun to make the news recently.  I don’t pretend to be an expert on bonds, but in the stock market these would be signs that the market is topping.  They are:

the hundred-year bond Norfolk Southern recently issued, at a price of about 101, $250 million in 6% unsecured notes due in 2015.  Yes, they’re redeemable, but at the company’s option, not the holders.  No, they’re not secured by the company’s physical assets.  Yes, they’re very sensitive to changes in interest rates.  No, trading them won’t be easy.

the mandatory convertible General Motors is planning to issue one along with common stock in its IPO.  Details of the GM mandatory haven’t been announced, but the idea is that it will initially be a preferred stock yielding, say, 5%.  After some specified period of time (two years?) the security will automatically convert into being common equity according to a formula that will give holders some protection against a decline in the new GM shares, and the company some relief it its stock is very strong.

One notable feature of this mandatory is the pik (pay-in-kind) option.  That is, GM can choose to pay the dividend in shares of GM stock rather than in cash.

Put another way, GM will be giving you a 10% discount for agreeing now to buy common stock around the then prevailing market price two years from now.  GM wins if the stock is 10% higher then than now.  And you win vs. buying the common now, if …?

bullish for stocks

To me, this all means that silly season for bond investors is in full swing.  This development is ultimately bullish for stocks, I think.  If investors are willing to buy these exotic instruments, can the purchase of stocks–even regarded as a funny type of bond–be far behind?

more on equity dividends, a badly misunderstood topic

August 22, 2010 By in Constructing a Portfolio, Current Market Thoughts, Dividends, Portfolio management Tags: , , , , , , , , Leave a comment

then…

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.

…and now

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.

why misunderstood?

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.

Here goes.

dividend basics

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.


Government bond market bubble? Wall Street Journal op ed column says Yes

August 19, 2010 By in Current Market Thoughts, Recent Market Action, Stock ideas, Strategy Tags: , , , , , , , , , , Leave a comment

frozen by CNBC

I had turned off my computer late yesterday morning and gotten ready to leave, when I decided I wanted to see how stock trading on Wall Street was progressing.  Rather than wait for my pc to boot up again, I turned the tv on to that financial reality show cum soap opera, CNBC.

Yes, there was the usual cast of buffoonish men and smart women.  They were making lots of inane comments in loud voices, trying at one and the same time to inject meaning and excitement into the random moment-to-moment movement of securities prices as well as to disguise their fundamental lack of knowledge/experience in the markets themselves.

Instead of simply looking at the market data and turning the tv off, I found myself listening with more than one ear to a “debate” about an op-ed column in that day’s Wall Street Journal, titled “The Great American Bond Bubble.”

“Artful’ is probably the word I’d use to describe the proceedings.  A CNBC talking head rambled passionately but incoherently.  Nevertheless, he was framed on the screen in the same group as the third-party bond experts appearing on the show, visually suggesting to the viewer that the Wall Street veterans endorsed his credentials.

One of the guests, a bond strategist from Pimco, said that the fact that the yield on the 5-year Treasury being 1.43% did not mean that bond prices were high.  How so?  …because the 2-year note yields .49% and the 10-year bond 2.63%.  Huh?  The fact that the yields on Treasuries of different maturities are internally consistent with one another says nothing about whether they’re cheap or expensive.   So what this guy said was possible true, but had no bearing on the point.

Another guest strategist–again avoiding the point–said it was outrageous for the op ed authors, UPenn professor Jeremy Siegel and his coworker at WisdomTree fund management, to recommend that investors sell all their Treasuries and buy stocks.

Think what you may about CNBC’s stock market expertise, the channel certainly hasn’t gotten where it is today by focussing on topics investors aren’t interested in.  So though I rarely read the WSJ any more, I thought I’d take a look at the op ed column.

“The Great American Bond Bubble”

The column makes a number of points:

1.  Nominal yields on Treasury bonds are extremely low.

2.  Yields on some inflation-adjusted Treasuries are negative in real terms.

3.  For taxable investors, after-tax returns are even less attractive.

4.  Despite this, investors continue to pour money into bond funds, a state of affairs the authors liken to the Internet stock mania of 1999.

5.  The justification for doing so is that “purveyors of pessimism” (read:  bond fund management companies) assert there are long-lasting “fierce headwinds against any economic recovery”–which the authors compare with the extreme optimism of Internet buffs a decade ago.

6.  Current securities prices–both stocks and bonds–are already discounting the worst possible outcome.  (I may not be doing justice to their argument, but I think this is it.  In fact, what I’m writing may be an improvement on what they say.)  Either the economic situation turns out to be as bad as the pessimists say (think: “new normal”), in which case securities prices don’t move very much; or at the first suggestion that we’ve passed the worst of the crisis bonds fall and stocks rise.

Therefore, “Those who are now crowding into bonds and bond funds are courting disaster.”

7. For income-oriented investors,  “value” stocks, that is, ones with low pe ratios and high dividend yields, are a much better bet.

my thoughts

First of all, it’s important to note that Mssrs. Siegel and Schwartz are both tied to WisdomTree, a fund management company founded by retired hedge fund manager, Michael Steinhardt.  No prizes for guessing what WisdomTree specializes in.  That’s right, value stock and dividend-oriented equity mutual funds and ETFs.  In a feat of linguistic legerdemain, WisdomTree calls its products “index” funds, even though the funds’ contents are selected/weighted according to decision rules devised by Mr. Siegel.  But that’s another story.

Similarly, as I’ve been writing about for some time, bond fund management companies have a similar vested interest in all world economies being pretty awful for an extended period.  It seems to me that this is the only scenario in which bonds, especially government bonds, won’t lose money.  The minute the US economy starts to get back on its feet, the Fed will withdraw the emergency monetary stimulus it is presently supplying and interest rates will rise–sending bond prices falling.  It’s not clear this will be an orderly process, either.

Myself, I think the op ed article makes a good point.  I’m not sure I’d endorse the entire top ten list that Professor Siegel provides.  He is a professor, after all, and not an investor.  I’d prefer companies that don’t have a history of cutting the dividend, as GE did during the financial crisis.  And much of VZN’s cash flow is contained in Verizon Wireless, its contentious joint venture with Vodafone, and therefore not readily available to distribute to VZN shareholders.  I’d also place more emphasis on firms that have been raising the dividend steadily, even if that means accepting a current yield of less than the 4% Mssrs. Siegel and Schwartz cite as average for the names they mention.  So I’d consider INTC, with a 3.2% current payout, or WMT at 2.4%.

There is one big feature that separates bonds from income stocks.  Bonds have a fixed maturity.  If you buy a 5-year Treasury for $1000, then when it matures in 2015 you’ll receive your $1000 back in full.  Not so with stocks.  Their value five years hence could be higher or lower, depending on market conditions.  Just look at the price of any US stock today and compare it with the quote in March 2009 for what is essentially the same economic entity and you’ll see what can happen.

Of course, one might observe that stocks rebounded quickly from this very low level–the yield on the entire stock market was higher than the 10-year bond yield then–and that the last previous instance of such a low was over thirty-five years earlier, in late 1974.  But neither point has made any difference to US investors.

One point is important to realize, however.  The  get-your-principal-back feature applies only to holders of individual bonds, not to holders of bond funds.  The latter are collections of bonds of varying maturities that don’t have a common due date.  So when you redeem your bond fund you have no assurance that you will recover your principal.  If you want your money from a bond fund during a period when the Fed is raising rates, I think there’s little chance of that favorable outcome happening.

For what it’s worth, stocks are subject to two opposing forces during a period of rising rates.  As financial instruments, better returns on a competing instrument (cash) means downward pressure on prices.  On the other hand, the Fed will only raise short-term interest rates if the economy s in good health and corporate profits are rising.  Profit gains tend to push stock prices up.  In the past, stocks have typically made gains during tug-of-war periods like this.


Wal-Mart’s 2Q2011: strong abroad, still suffering from recession in the US

August 18, 2010 By in Current Market Thoughts, earnings conference calls, economics, Stock ideas Tags: , , , , , , , , , , Leave a comment

the results

WMT reported 2Q2011 (fiscal 2011 ends January 2011) before the market open in New York yesterday.  The company earned $.97 a share, up 9% vs.  $.89 a share achieved in the same period of the previous fiscal year.  That was a penny ahead of the Wall Street consensus.  The company raised its full year earnings guidance by $.05 to a range of $3.95 to $4.05.  (2Q2010 was originally reported as $.88, but the installation of a new SAP management control software system has given WMT better knowledge of its inventories, resulting in the restatement.)

details

Three-quarters of WMT’s revenues come from the US.  The other quarter of the firm’s sales, along with virtually all its growth at present, comes from abroad.  The company is very strong in Mexico, and is expanding rapidly in Brazil and China.

Overall sales for the three months for Wal-Mart US were flat for the three months ending July, same store sales down 1.8% and operating incoe doan .2%.

Sam’s Clubs’ sales were up 2% for the July quarter, same store sales (ex fuel) up 1% and operating income up 2.4%.

International sales were up 11% and operating income up 16.8% (on a constant currency basis, both figures would have been about 4 percentage points lower).  Same store sales were up about 6% in China and 3% in Mexico and Brazil.  Japan and the UK were up slightly.

It seems to me that this general picture, aided by cost control, will continue at least for the rest of the fiscal year.

Since Wal-Mart is such a dominant factor in retail in the US, and because about a third of its customer base consists of lower middle class shoppers, Wal-Mart’s US results give some insight to the economic condition of ordinary American residents.

a Wal-Mart’s-eye view of the US

Wal-Mart reported that its business exited the quarter stronger than it began the three months and the traffic was improving sequentially.  But the image the company reveals of its customers’ buying tendencies–Wal-Mart has superb information systems–is one of continuing struggle.

For example, many customers are living paycheck to paycheck.  So Wal-Mart sees a surge in sales on payday, followed by a gradual tailing off until the next paycheck is issued.  Use of food stamps and other forms of government assistance is rising.  Use of the company’s check-cashing services is up by more than 10%.  Credit card usage, now at 15% of sales (30% is about average for retail overall), continues to fall.

Grocery sales are up.  Baking and cooking supplies are, too, as more people shift from eating out to preparing meals at home.  Apparel sales (never a Wal-Mart strength) are down, as are home goods and appliances and electronics.  In other words, necessities are in, discretionary purchases are out.

This may not be a strictly apples to apples comparison.  Wal-Mart performed relatively well during the worst of the recession, helped in part by shoppers trading down from more expensive stores.  Industry evidence is that many of these customers have begun to trade up again.  Still, it’s clear that many Wal-Mart customers are having a very rough time.

Last year, apparently in a bid to woo more affluent customers, Wal-Mart tried two experiments.  It cleared its normally crowded aisles and reduced the number of items sold in many categories–apparently to give a more Target-like look.  It also increased advertising.  Neither experiment worked.  So the company is increasing assortments again, delegating more merchandising authority to local managers and stopping the extra advertising.

On the positive side, Wal-Mart says that after its success in entering the Chicago urban market it has been contacted by a number of large cities asking the company to do the same for them.

the stock

WMT (I own it) is trading at under 13x earnings and yielding 2.4%.  It is generating free cash flow of over $4 billion a quarter and has used $7 billion of that in the first half to buy back stock.  the earnings growth rate should gradually improve, both as international operations become a large part of the whole and as the economy rebounds from the current cyclical low point for Wal-Mart customers.  For an income-oriented investor, I think WMT is way better than a government bond–admittedly more volatile–but way better.