Dividends: A Company's Leading Indicator 16 comments
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Traditional thinking about dividends is that low-paying stocks provide greater growth potential, because the company is fueling future growth by plowing more money back into the company. The so-called “sustainable growth model” (SGM) is based on this concept, holding that the maximum growth rate is achieved with zero dividends paid out. Stated another way, SGM purports to show that when a firm pays dividends, earnings growth lessens.
Does that academic formulation really play out in the real world? In the best Sensible Stock Investing tradition, let’s toss aside conventional wisdom for a moment, start with a blank sheet of paper, and think about this.
The first thought that comes to mind is that—in an established company with a long-standing tradition and practice of raising its dividend annually—the amount by which a company raises (or lowers) its dividend gives great insight into what company management sees in its future. In other words, the amount by which a company raises its dividend is a leading indicator of how management sees the company’s fortunes over, say, the next two-three years. Furthermore, in contrast to SGM, common sense suggests that the higher the dividend increase, the better the outlook for the company. Not only must current cash flow be plentiful (to pay the dividend), the dividend declaration probably reflects management’s confidence in the stability and growth of future earnings, quite possibly based on information that is not publicly available.
In the lead article of this month’s AAII Journal (written by Stanley Block), this idea is buttressed by a discussion of two studies performed in 2003 and 2006. In a nutshell, the studies found that higher dividends = higher earnings growth. One study was done with aggregate market data; the other used stock-by-stock analysis. The authors of the latter study stated, “Our tests…show that high-dividend-payout companies tend to experience strong, not weak, future earnings growth.” (AAII Journal, May 2009, p.5.)
Why should that be? Several reasons:
-First and most obviously, SGM assumes that retained profits will always be used wisely in a way that creates value and growth. But in the real world, retained profits are not always used wisely. I have worked in large corporations and seen examples of dumb capital allocation: Ridiculous pet projects, over-priced acquisitions, out-of-control pay and bonus structures, multiple false starts on good initiatives (like IT upgrades), overstaffing at the top while squeezing the real wealth creators who do the work, constant reorganization with high collateral expenses (and often damage)—the list is long.
-As stated in the AAII article (and I have definitely seen this too), “high earnings retention…may signal an attempt at empire-building by current management.”
-And “management may engage in developmental projects that do not represent the best interests of stockholders.”
-And “the main recycling [of potential dividend dollars] has been toward share repurchases.”
As I have stated elsewhere, a company that pays dividends will probably invest the earnings it does retain more carefully. The dividend program imposes discipline on management. With less money to play around with, management will tend to be more careful about what it does with the remaining money.
There are several interesting tables in the AAII article. Two of the tables compare the dividend yields and stock price performance of the 30 Dow Jones Industrial Average stocks between 1/1/04 and 6/30/08, a period of 4 ½ years. Dividing the stocks into two groups—those that yielded more than 2% or less than 2% at the beginning of the period, the author demonstrates that the higher-yielding stocks far outperformed the lower-yielding ones. For the duration of the period, the 16 higher-yielding stocks averaged a capital gain of 32% (median 20%). The 14 lower-yielding stocks averaged capital gains of -1% (median +2%). The difference could hardly be more stark. (For comparison, over the study period, the DJIA was up almost 9%.)
Now obviously, the proposition that high-yielding stocks outperform low-yielding stocks is not foolproof. In the study, not every high-yielding stock performed well. For example, General Motors (GM), with a 4.2% initial yield, lost 76% in price during the study period. And not every low-yielding stock performed poorly: Hewlett-Packard (HPQ), with an initial yield of 1.4%, rose 92% in price. But the averages and medians of the complete lists were as stated above.
As the author of the AAII article states, the reasoning about dividends does not apply to young companies, who generally must retain all of their earnings to fuel their early growth. Another caveat is that having a well established dividend-raising culture and practice does not guarantee that a company is not in trouble. Management sometimes misgauges. Nowhere has this been more true than in the financial industry over the past year or two. I’ll have a little more to say about such companies at the end of this article.
I follow several dozen dividend stocks, all of which have solid dividend-raising cultures. (Those are the only logical stocks for a dividend investor to consider.) Many have raised their dividends for 20-25 years or more. So far this year, several of them have declared significant dividend increases: Abbott (ABT) 11%; Coca-Cola (KO) 8%; Colgate-Palmolive (CL) 10%; and Procter & Gamble (PG) 10%. I would say that for each of these companies, the strong dividend increase signals that management feels it has good visibility of healthy earnings growth over the next couple of years (at least). No one on the management team in any of these companies wants to raise the dividend to such an amount that there is any danger that they might have to freeze or cut it in the future.
On the other hand, some of the companies I follow, while also long-term dividend raisers, have declared increases this year that are tepid or little more than symbolic: Air Products (APD) 2%; AT&T (T) 3%; Sherwin-Williams (SHW) 1%; and 3M (MMM) 2%. These small increases suggest that management is unclear about the next year or two, and therefore is avoiding the possibility of a future freeze or cut by holding this year’s increase to a nominal amount. That keeps their streak of consecutive increases going, but (hopefully) does not endanger it in the future by setting the dividend so high that it cannot continue to be increased. Management is prudently taking a breather during hard times.
And, of course, there are companies in the middle, raising their dividends neither by really large amounts nor playing defense with tiny increases. Examples would be Chubb (CB) 6%; Waste Management (WMI) 7%; PepsiCo (PEP) 6%; and Southern (SO) 4%. Given the general economic climate, these increases are actually pretty good, but they also reflect a cautious attitude. That is totally fine with me as a dividend investor. I want these companies to be managed prudently, and for them to spin out increasing dividends for years to come.
What about companies that have cut their dividends? Only one that I follow closely (Diageo, DEO, -25%) falls into this category so far this year. Clearly, I think this reflects the company’s felt need to conserve capital as they look at a future performance outlook that is at best unclear and may well be negative.
One can’t talk about dividend slashing without thinking about what has gone on with banks. Many of them have severely slashed or even eliminated their dividends during the past year. That fits perfectly with the earlier premise: If healthy dividend raises suggest healthy future earnings growth, then dividend cuts suggest cloudy or unattainable earnings growth. Obviously these are companies in trouble.
Interestingly, for several months, most of their trouble was predictable from basic analysis of their financials, or from their “stories” (including acquisitions made or TARP funds taken). I am surprised that these stocks remained on some “dividend buy” lists right into 2009. One, BB&T (BBT) continued to be held by at least one highly respected dividend writer right up until—well, right up until it slashed its dividend last week by 68%.
Here’s my two cents on banks as dividend investments:
-Most banks must be considered speculative investments until further notice. For the long-term dividend investor, that means you can take almost all of them off your watch lists.
-That especially applies to banks that took TARP funds. Their focus is now forced to be on capital building and repaying TARP. Many are issuing scads of new shares as one avenue to raising capital. BBT, for example, is selling 15% more shares. Their focus cannot be on restoring their former dividend.
-Traditionally, banks have been reliable dividend generators. There is absolutely no guarantee that they will return to that status anytime soon. Nobody knows whether the general rule that "banks pay good dividends" is still true. We may be seeing a paradigm shift in what it means to be a bank, especially with all the current government involvement and new banking regulations likely in the offing.
-Even after the current climate ends, and banks are out from under direct government involvement, there is no way to predict when they will be able to regain the earnings-generating capacity that would be required for them to be the dividend payers they once were. I have seen blithely confident statements that banks will be back to their old dividend-paying ways shortly, like in a year or two. I have no idea how anyone can be confident about that.
Finally, not so long ago, the troubled banks were on S&P’s Dividend Aristocrat and similar lists of companies with many years of uninterrupted dividend growth. What happened to them underscores why such lists are just starting tools for the attentive dividend investor. Each stock must be examined one at a time for its business standing, its financials, and whether its dividend is at risk. Dividend investing is a long-term strategy that must be executed carefully. Every stock that pays a dividend is not an appropriate holding for a serious dividend investor. And once purchased, dividend stocks cannot just be stuck in a drawer. One should review all holdings once or twice per year and analyze them to see which companies, because of their business situation, are likely to need to cut their dividend to preserve cash. Most dividends in peril are predictable.
Disclosure: Long ABT, CL, PG, T, SHW, MMM, PEP, and SO
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This article has 16 comments:
This was a good article.
I have already written such an article. It examines the interplay between dividend yield and dividend growth rates. Here it is: seekingalpha.com/artic...
Dave
1. Stock buy-backs - these are a tax efficient equivalent of dividends. Many companies that have extra free cash flow will buy back stock instead of paying more dividends. Management wants to show steady increases in dividends and they never want to cut them as they know many widows and orphans depend on the income. So they buy back their own stock. In my opinion this is an invention of the devil. Managements are notoriously over optimistic about the value of their own stock. They will buy back stock to offset the increase in shares from stock options, which hides how much regular shareholders are being diluted. Tech companies like Yahoo horde cash for future growth and acquisitions. That hasn't always been a successful strategy. It's my money, dammit. I'd prefer to pay the taxes and reinvest the money myself.
2. Neither the economy nor companies growth at a steady pace. Therefore how can dividends grow at a steady pace? I think the desire to produce a long track record of steady dividend growth has caused management to underpay dividends. Also there will be periods where companies have great opportunities to make attractive investments and compound capital much faster than an individual can do on his own. In a perfect world it would make sense for a company to reduce or even suspend its dividend rather than pay an investment banker to raise more capital, if it was available. I know this variable dividend policy is unlikely to be enacted by any company but it makes economic sense.
Disaster: As to factors to look for, I'll first plug my own e-book: "The Top 40 Dividend Stocks for 2009: Dividend Investing for the Long Haul." I have a complete system for "scoring" dividend stocks, and it is fully explained there, along with the 40 stocks that emerged this year as the best dividend stocks. Go here for a complete description: www.sensiblestocks.com...
For an overview of what I think are the most important characteristics of good dividend stocks, this article on Seeking Alpha sums them up: seekingalpha.com/artic...
Skip: I agree with you, I hate share buybacks. I've writtten articles about how dividends are much better for shareholders. Here's one if you care to look at it: www.sensiblestocks.com...
In addition to the factors you cited, companies often buy back their own shares at high valuations--they do that because they have the money to do so; they have the money because they've had a good year or two; and because of that, their share prices tend to be high when they announce a buyback program. It's hard for me to think of anything I like about share buybacks versus dividends, even though they are often equated as "ways companies return money to shareholders." They are not equivalent at all.
On your second point, I think there actually are companies whose dividend policies lead to low (or no) dividends, and the theory is exactly as you state: Their internal opportunities are attractive and they want to invest in them. That's fine. If it all works out, theoretically the company will grow, and that growth will be reflected in its stock price. That's how the investor makes money.
But if you are a dividend investor, you are working on a different strategy altogether...the collection of dividends, which you can reinvest to compound faster, or spend, or do whatever you want. For a dividend-growth strategy, you generally want your companies to be raising their dividends regularly. That's what fuels your own growth. If you are a truly committed dividend investor, you care far less about the price of your stock than someone who is following a capital-appreciation strategy (as in the preceding paragraph). In fact, you may be happy when the price of your stock drops, because (if you are reinvesting), you can buy more shares at a higher yield when the price is lower.
"What is a dividend?" I recently asked , before reading your article.
Investors deplore the slashing and view a stock's price, in hard times especially, by its yield. A dividend is not to be sought as a harbinger of retrenchment (and consequent reduced yields) nowadays, but those "glimmers" people hope for, in testimony to SOLID projections for a company's future.
If the slashing of GE's dividend from $.31 to $.10 is a "proxy for the economy," it is GE's (and it certainly will NOT lead the charge,) and others', eventual viewing (beyond their present curtailment) of resurging earnings we must look to. When such a view translates into IMPROVING dividends, thereby enhancing investors' and consumers' confidence, by virtue of a board's courage to stake such a claim on its future, THEN we have proof of a better day. Dividends as HERALDS of a robust economy, rather than the collective CABOOSE of an impaired marketplace. THEN we have dividends anwsering to their higher calling.
I had owned Southern Company for quite a while, until this cap-&-trade business started.
I quickly got out and had everyone I'd put in it get out.
Do you not fear what will happen to utilities if that craziness passes?
I sure like to see someone make that point once in a while. There seems to be this prevailing "conventional wisdom" that dividends should always be reinvested, and not to do so is unwise.
I beg to differ.
Blind adherence to any investment approach just because "they" all advocate it may be bad for some people. People who don't make a lot of money have so many things stacked against them if they try to get anywhere financially. "Life's little emergencies" seem to come just often enough to nickel-and-dime their savings away every time they manage to accumulate any. "Something" always happens.
A time-honored, sensible strategy of investing in utilities and good market-leading companies for the dividend income can enable these people to "ratchet up" their income if only they choose to defy this "conventional wisdom" and elect to receive their dividends instead of reinvesting them. As they increase their income, the increased income helps to insulate them from one of life's little disasters wiping them out and forcing them to start over again.
Hey. I make a little less than $9 an hour. I think of my dividends as "extra paychecks" I didn't have to work for. My "extra paychecks" started out few and small. Now there's more of them - and they're bigger. As I save and buy more shares my income goes up and I can save more money faster.
Want an economic stimulus? Financial literacy should be taught in our schools. What if everyone down here at my income level knew how to do what I'm doing? Investing for dividends and BUYING dozens of "extra paychecks per year and working on buying more shares and making them bigger has dramatically improved my life. I have NO DOUBT about my eventual financial independence.
Results = faith
This works. I have lots of faith. The results are undeniable. Strange how many people will argue with success.
Buffett is an interesting case: no dividends and no stock buy backs. Stock appreciation of BRKA from inception on Jan 12, 1990 is 13.3% vs. 5.4% for the S&P 500 and 7.6% for NASDAQ. Considering taxes, you would have had to earn more from dividends than Buffett's 13.3%. But then, had you bought BRKA in the second quarter of 1998 at close to $80 K, you would be in sad shape.
Buying at the right time is very important, the lower you buy the higher the dividend yield you get.