For a long time, I considered dividends about as relevant as stock splits: Yes, they both could serve as signals of management’s confidence in the outlook, but neither event changed the underlying value of the company. Of course, in a post-Enron world, where taxation laws were easily changed to encourage the payment of dividends, we have seen a change in the landscape, with many more companies paying them and more investors caring. I am not so sure that it has had any effect whatsoever on returns, but there is no denying that they have become more important to investors. Even I, who doesn’t care personally about receiving dividend income, would prefer to see my investments in more mature companies have at least a nominal dividend. WellPoint (WLP) comes to mind as one that should but doesn’t. One can only wonder how their implementing a dividend policy might help the stock.
We could argue until we are blue in the face about the impact of stock splits and dividends (and share repurchases for that matter). On the one hand, standard finance theory, which assumes efficient markets, would suggest that as long as a company isn’t reinvesting cash below its cost of capital, there is little reason to return it to shareholders. Behavioral finance, though, would key in on the “signals”. Most of the rest of us would probably realize that markets aren’t always that efficient, at least in the short-run.
Back in late December, I submitted three stocks for a quarterly contest (the “Alpha Cup”) in which several investment professionals who meet monthly for a dinner participate. One of my stocks was a short (New Century (NEW)). As an aside, I finally won the contest, but my two longs were sufficient to do so without the help from the pick of a lifetime! At the time, the stock was yielding a whopping 22%. In fact, we met the day after it went ex-dividend for the last time. I mention this because it is a great example of the importance of understanding the safety and security of a dividend. Investors should care not only about today’s dividend, but also tomorrow’s. Of course, tomorrow’s dividend depends upon tomorrow’s earnings. So, how should an investor who cares about dividends approach stocks?
Well, as the New Century example clearly demonstrates, high yields aren’t necessarily the best yields. If the investor starts with the present dividend yield, it is essential to understand where it is coming from and where it is headed. First, the investor should examine the balance sheet – is it laden with debt? Is that debt due soon? Are there other problems, like excess inventory or accumulating receivables? Next, the investor should examine the “payout ratio”, which is essentially the dividend divided by the earnings. If the company is paying out today more than it is making, then the likelihood of continuing to receive that dividend might be low. If it paying out very little, then there is room to grow. Finally, one should have an understanding of the value of the stock, which will obviously relate to the other two issues discussed. After all, the return on the investment is not only the dividends that the investor receives over time, but also the difference between the purchase and sale prices.
As I mentioned above, dividends don’t matter to me at this stage in my life. I do, however, recognize the increasing importance to others. With the changing demographics, investors will probably have an even greater demand for dividends in the coming years. While some might suggest that this implies one should go out and buy today the high payers, I would suggest otherwise. Now is the time to buy the stocks that will be paying big dividends in the future. With that in mind, I constructed a screen (using StockVal) that I believe is helpful in identifying Conservative Growth Stocks that should be in high demand as the baby-boomers retire. The parameters that generate this list of 32 stocks include a minimum 2% yield, a maximum payout ratio of 80%, minimum 3yr growth in EPS, RPS and Dividends of 5%, Return on Capital in excess of 10%, no more than a 50% premium to the 5yr median PE and relatively stable earnings estimates. Additionally, all of these stocks have paid dividends for at least the past 10 years.
Disclosure: Author is long WLP, which is mentioned in the article but, regretfully, not included in the list due to its lack of dividend.