When companies are young and growing very fast, they rarely pay dividends. Instead, they retain earnings in order to fund their voracious need for capital. During this stage, growth is how shareholders can expect to be rewarded. Of course with growth comes high PE ratios and price volatility, which of course implies higher risk.
As companies mature, they require less capital to fund growth and therefore have more flexibility regarding rewarding shareholders. Generally speaking they can make acquisitions, institute share buybacks and of course pay dividends. Many will engage in all three uses of capital. Regarding dividends, payout ratios tend to start low and increase over time. This is generally due to the fact that more mature companies that are still growing moderately fast require some of their capital to continue funding expansion.
However, as companies mature, growth slows down because, typically, the law of large numbers comes in to play. Consequently, at this stage dividends are paid in order to attract and retain capital and shareholders. Therefore, payouts tend to be higher to even very high as earnings growth tends to weaken. As a result there is a correlation that the highest yielding dividend payers generate the lowest total returns. Of course, all of the above are general statements and apply to operating companies. Exceptions can be found in real estate investment trusts (REITs) and master limited partnerships (MLP’s) etc.
Part 2: Last-Ten of Dow 30 Best Performers
In this, our final part 3 of our series, we will cover the 10 worst performers of the 30. Consistent with the previous statements, these 10 worst performers had the highest equal weighted current yield of the three sets of ten companies at 3.18%. This group also had the slowest earnings growth and many have the highest payout ratios.
Figure one below provides and overview of the ten worst performing Dow 30 stocks since 1996. They are listed in order of highest total return to lowest. Take note that Kraft Foods Inc. (KFT) and Travelers Cos, Inc. (TRV) are presented over different time periods due to spin offs and corporate re-organizations. Therefore, these two companies need to be reviewed with this in mind.
Figure 2a & b: Bank of America Corp. (BAC)
Our first worst performer of the Dow 30 is Bank of America Corp. For the first eleven years, on Figure 2a, BAC's earnings and dividends were growing nicely and stock price followed. The financial meltdown caused earnings to collapse and once again stock price followed. This once high dividend achiever was forced to slash its dividend from $2.24 in 2008 to $0.04 in 2009 (see Figure 2b). Therefore, the idea that high dividend achievers create the best returns failed to manifest. However, the idea that earnings determine market price (and dividend income) prevailed.
Figure 3a & b: Walt Disney Co. (DIS)
Disney, once a consistent and strong earnings grower, has in more recent times become a cyclical business. Therefore, a low and inconsistent earnings growth rate of 5.7% led to poor capital appreciation and a rather anemic dividend income stream. A lot of price volatility at times may have appealed to the day trader; however, prudent long-term investors seeking reliable growth and income may be advised to look elsewhere.
Figure 4a & b: Coca-Cola Co. (KO)
Coca-Cola has a consistent and moderately attractive record of earnings growth and a solid record of increasing their dividend in line with earnings growth. However, Coca-Cola represents a vivid depiction of the importance of valuation. Since it was overvalued throughout most of this 14+ year period, shareholder returns were far less than earnings justified. This places a spotlight on both the power and importance of dividends. In this example, dividends represented almost half (47.5%) of total return. Since it returned to its earnings justified valuation (the black price line touching the green earnings line), we have added it to our growth and income portfolio.
Figure 5a & b: Merck & Co. (MRK)
As can be seen by the area highlighted in red at the bottom of figure 5a, in the early part of this period, Merck was an above-average growth stock, where earnings growth annualized at 17.1% and generated a strong and rising dividend. From calendar year 2001 forward, Merck's earnings became both flat and inconsistent, averaging a mere 1.4% annualized. During this period, dividend growth slowed with earnings growth and the dividend was even cut once in 2007. Once again, this illustrates the importance of earnings.
Figure 6a & b: AT&T, Inc. (T)
AT&T generated a very low earnings growth rate of 2.4% and a moderate degree of cyclicality over this 14+ year period. A high beginning valuation resulted in a negative capital return for the period. In this case, what return there was came exclusively from dividends. Also note that AT&T had the second highest yield of the thirty Dow stocks covered in this series and yet one of the lowest total returns.
Figure 7a & b: Du Pont (DD)
Du Pont is another example of poor earnings impacting returns. An actual negative growth rate of earnings was saved by a lower beginning valuation for the period and a higher valuation at the end. Therefore, the original $100,000 principle value of the original investment was maintained. Consequently, the meager total shareholder return of 3.3%, which turned our hypothetical $100,000 investment into $157,739.62, can be attributed almost exclusively to dividends. Of the $57,739.62 of total return, $56,366.22 came from dividends and only $1,373.40 came from capital appreciation.
Figure 8a & b: Alcoa, Inc. (AA)
The Alcoa story strongly resembles Du Pont's story in Figures 7a and b. No meaningful earnings growth led to very poor long-term shareholder returns. Like Du Pont, almost all of the shareholder returns came from dividends, however, the dividend record was very erratic, due its inconsistent earnings record. Alcoa is a cyclical stock, as most materials and metals are.
Figure 9a & b: Verizon Communications, Inc. (VZ)
Verizon is a classic example of a typical utility investment. Though they have high current yields (of the thirty Dow stocks, only AT&T and Verizon have yields above 6%), they tend to generate very poor long-term total returns, because earnings growth is typically regulated to very low numbers. Therefore, as Figure 9b illustrates, capital actually shrunk with only dividend providing any long-term return, as small as it was.
Figure 10a & b: Kraft Foods, Inc. (KFT)
Since Kraft Foods was spun off from Phillip Morris, we do not have a full 14+ year track record to report on. However, from Figure 10a, it is very clear that from 2003 through current, Kraft's earnings growth was virtually non-existent. They earned $2.02 in 2002, which is only estimated to grow to $2.06 in 2010. Therefore, dividends produced all of the shareholder returns for the period reported from June 29, 2001 to current. Based on Kraft's current historically low valuation, we are including it in our growth and income portfolio, due to its ten-year t-bond approximating yield.
Figure 11a & b: Travelers Companies, Inc. (TRV)
We are only reporting Travelers since just prior to its transformation from St. Paul Travelers to the current Travelers company. However, relationships for this period between earnings, valuations, and the importance of dividends remain intact.
We hope this series on dissecting the Dow 30 provided readers a greater insight into the importance of dividends and their relationship to total returns. Most importantly, we are hopeful that insights were also gained regarding the important roles that earnings growth (operating results) and valuation play in the investing process.
As we pointed out in part one, we gravitate towards specific and thorough analysis in lieu of generalities or statistical references. It’s not our contention that studies or statistical representations are wrong. Instead, we contend that they can be misleading or provide an incomplete picture. When more rigorous analysis can be conducted a greater understanding should follow.
With the Dow Jones Industrial Average only consisting of 30 stocks, we saw this as an opportunity to examine a commonly used index as a proxy for the market, in greater detail. The same work could be done with our F.A.S.T. Graphs™ or other indices like the S&P 500 or Russell 1000. However with that many stocks to look at only the most devoted could get through it. We hope you found this series both enlightening and meaningful.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long KO, KFT at the time of writing.