When a Yield Sounds Too Good to Be True...

When looking at a stock, it can be awfully tempting to blindly look at the dividend yield as support for it being a good investment. After all, if you can be earning 5%,7%, or even 10% on your money from dividends, that sure beats a savings account. After all, the money is in the bag, right?

In particular, I have closely been following the action of these three companies that are currently sporting yields well above their 5-year trailing average and are paying out more than 100%.

click to enlarge

I am not going to come out and say that these companies are screaming buys. For the sake of disclosure, I am long SBCF and PFE. I do not hold a position in BAC. Specifically, I am more interested in the apparent imbalance each of these three companies are showing and trying to make sense of it.

Obviously, yields become high when the stock price is beaten down and none of these companies has been immune from that. Certainly, we have seen dividends significantly cut or eliminated in companies such as National City (NCC), Washington Mutual (WM) and General Motors (GM). However, those companies needed to reduce the dividend to raise capital, meet liquidity requirements, or frankly just stay in business. For the above three, that is not the case. Additionally, each of these companies has indicated that their respective dividends will actually be maintained – not just for this quarter, but for the foreseeable future. Let's briefly look at each one.

Bank of America (BAC)

Typically, the 8.3% yield would be enough to scare anyone away, but what is really happening at BAC? Despite having its set backs and challenges, BAC has been able to remain profitable and is insistent that there is no reason to cut the dividend. The deal with Countrywide was also allowed to close and BAC's consensus is that they got the troubled lender for a steal. BAC is trading below book value and analysts have set price targets on it even lower than current levels. Nowadays, there always seems to be one more skeleton in the closet that comes to light, but BAC is quietly confident that will not be their fate. The fact that they are not yelling in the streets about their position, unlike companies such as National City, Lehman Brothers and Bear Stearns before their flounders, is something to take into consideration.

Pfizer (PFE)

PFE is flush with cash and a 40+ year history of not only paying dividends, but annually raising it. The market is digesting the upcoming patent loss of Lipitor, but the company is using its cash to buy back shares and pay dividends. Many thought the floor on the stock was when the yield was at 5%. Since then, PFE has raised the dividend and the performance of the stock price has driven the yield to over 7%. Undoubtedly, the company has seen some challenges in its business, but PFE is certainly not teetering at the edge of any insolvency disaster.

Seacoast Banking Corp. of Florida (SBCF)

SBCF is certainly the oddball on the list. It would take 723 SBCFs to make one BAC in terms of market capitalization, but they do fit the profile. SBCF is trading at 85% of book value (which saw an uptick last quarter) and again is insistent that the dividend will be maintained as long as possible. The bank also remains profitable, is not insanely leveraged like many of its peer banks, and does not need to raise capital and has no plans to (SBCF, did, however file a shelf-registration but said they probably will not use it).

Dividends are certainly an ownership consideration. It is nice to get some cash back in your pocket for owning the stock. After all, that is what owning a business is all about. However, when yields are well above historical norm, it is telling us one of three things: (1) the dividend is too high; (2) the stock price is too low; (3) both.

From a practical standpoint, a company will cut their dividend when extra capital is quickly needed (whether it be to meet liquidity requirements or fund an expansion) or when the earnings are not there to support it. In the latter, it is pretty common knowledge that it is not wise to pay out more to your owners than you make. So, what is the rationale for each of these three companies to increase and maintain their dividend rather than cut or outright eliminate it?

Although mathematically, the companies cannot afford it, BAC put it best when they said there was no real reason to cut the dividend. The cash saved from cutting the dividend would only go back to the coffers and augment the book value of the stock. In these case of each of these three, it is not as though the companies need the cash to stay afloat or to stay solvent. It is the old adage, if it is not broken, don't fix it.

Some have cited these companies are fighting the tide and just keeping the dividend to maintain face or preserve tradition. Sadly enough, egos get in the way of even the most obvious of business deals. Remember Ballmer's no-brainer bid for Yahoo!? Ballmer made the bid to make it easy to say yes, but it was spurned. Yahoo! cited business reasons, but how much ego was involved. It is hard to say. Certainly, the directors of these companies would not want to see some of their income go away, but I am willing to guess the meeting to discuss maintaining the dividend consisted more of a chest-thumping session. That is a possibility, but if you look at the actions of each of these three companies, there has not been a lot of megalomaniacal activity.

SBCF started cutting their business back in the summer of 2006, a full year before the credit crisis started to come out in the open. It was likely a humbling experience for SBCF and there must have been moments where they felt like they were missing the boat. The market continued to be red hot the following year and industry related stocks reached further highs and watching their neighbor get snatched up for a big premium (at least at the time). Like in a football game, it may be tempting to go for it on 4th and 1 at midfield, but punting is a real exercise in logic and humility. SBCF did exactly this in late 2006 and their financials reflect this decision – this is further demonstrated by the lack of a massive dividend increase in 2006 or 2007. Opting to punt in a time of uncertainty and shun any takeover transaction has made SBCF look pretty smart. Any deal they would have taken would likely have seen the stock become worth ½ of the overall buy out price – and in some cases, almost eradicated completely. Plus, SBCF remains in control of their own destiny and not subject to the whims and fall-outs of a nationwide chain. This has kept SBCF in business for 80 years.

PFE has since seen some management changes and while the stock price has suffered greatly the past two years, PFE has not shown any acts of desperation to try to cling to its former strength. PFE's strategy has been to buy back shares, cut costs by reducing jobs, and to hold off on pursuing any ultra-expensive acquisitions to try to rebuild their aging pipeline. Incidentally, it is the latter that Wall Street is yelling and screaming for them to do and what the street claims will save PFE and replace the future of lost revenues. It must be tempting for PFE to pull the trigger and be the hero, but in the near-term, this does not appear to be in PFE's path. I have heard some say that PFE will lose 25% of their revenues when Lipitor's patent expires. There is no doubt this will not be a fun one for PFE to lose, but is the street really anticipating that PFE will be totally incapable of replacing the lost revenue stream? Granted, it may take more drugs and greater research costs, but come patent expiration time, I think it would be silly to bet to see a gaping hole that PFE will just ignore and say whatever.

BAC's prudence (or at least humility) was illustrated by getting the Countrywide deal through regulators. BAC has certainly been impacted by the industry and has taken their share of write downs. The CFC deal approval is interesting as it likely took some humbling discussions with the Federal Reserve to gain approval. We are already seeing more government scrutiny on banks and practices and it is a safe assumption that a deal between two bad entities would not receive approval. After all, 2 wrongs do not make a right. Additionally, in the April 21, 2008 earnings announcement, Ken Lewis, BAC's CEO, was very straightforward in addressing the company's shortcomings and problems. Of course, being honest does not mean BAC is going to do well going forward, but compare his comments in the release and conference call to that of the companies that suffered huge collapses, such as Bear Stearns, Lehman Brothers, and National City. The reality of the statements might lead to punishing of the stock price, but it is certainly devoid of any self-serving behavior. BAC also cited strength in their 'core business' – the identical words used by SBCF in describing their position.

The biggest argument I have heard against these companies keeping their dividend all centers around things like pride, denial, egomania, and tradition. In many cases, that certainly could be the case. Again, I would like to believe that the board rooms of these companies are purely objective and not motivated by ego, but sadly, we all know that is not fully the case. However, the actions and comments from each of these three companies indicate a lack of such animated behavior. If anything, it reflects on the humility that each of the company's cultures fosters. That is an intangible observation, but sometimes, that is the answer.

Going forward, yes, at some point, these companies are going to have to get payout ratios back in line and be less than 100%. That is a tangible observation. You cannot pay out more than you make out indefinitely. Regulations and sheer mathematics preclude such nonsense. However, in the case of each of these three companies, I cite the following:

1. During the short-term, each of these companies can easily fund their dividends from existing liquidity without taking too much of a balance sheet beating;

2. Nobody on the street has indicated a genuine reason why these companies should pull the dividend, other than simple addition or pride. Obviously, numbers count for something, but I think even the most sophisticated investor can remember many occasions where the numbers only just never amounted to anything;

3. Based on the prudent, almost boring actions of these companies the past year, should a dividend reduction be necessary, there is no doubt the boards will come to the table and make that humbling decision – but they will do so only if regulations force the issue or if the opportunity arises to better use that cash to invest in the business;

4. Despite enormous internal (PFE) and industry challenges (BAC, SBCF), all have remained profitable through effective business management and there is nothing to indicate that profitability is in jeopardy for any of these companies.

Achieving success in real-life is often a thin line that needs to be walked. Each of these companies is doing what they believe is in the best interest of their shareholders and their company. They have all made mistakes and suffered set backs, but all were upfront in coming to the table and taking preventive measures to insure the fall out did not exceed worst case estimates. The stock prices of these will continue to remain under pressure until the market changes its mind. The dividends, however, for the time being, are safe – of course, with a risk existing of them going away – but with 7%+ yields, isn't risk part of the deal?

I am not saying these are screaming buys. I am not saying to go on faith that the yield will take care of your investment. The downside could still exceed the yields. I do, however, see three companies that have likely had serious discussions about the feasibility of their dividend payments and payout ratios. For reasons we are not currently privy to see, this is the best place to use that block of capital until things improve.

Disclosure: Long

Comments

[jacob79:]

let us go back to the old bodring days ...
when investment meant ,buying a stock and geting dividend ,
plus little appreciation.
all the rest is pure las vegas gambling...
and we saw the consequences lately

2008 Jun 11 02:20 AM

[danthetaxman:]

IF the stock market is truly efficient, stock price equals risk adjusted, discounted after-tax projected cash flows. Having worked closely for years with the inside financial "powers that be" as an analyst for DuPont, and as a consultant for Hewlett-Packard, rarely did management fully disclose/make realistic provision for, contingencies. Doubtful that BAC is any different. As such, my prediction is that BAC cannot/will not maintain their current dividend levels. Else, BAC would not be trading at $30 per share and yielding over 8%.

2008 Jun 11 06:02 AM

[notsosmart:]

its all turned into vegas or the other casinos only slower. you cant believe anything anyone says cause they all have an agenda & they dont know.so roll the dice,push the button,spin the wheel & hit me again!

2008 Jun 11 09:06 AM

[Iknownothing:]

Generally over the long term the market...in its totality...
is fairly efficient. But in the short term, there are sometimes when the risk-reward equation gets way out of balance.

This is one of those times. Probably the greatest in my very rewarding 50 plus years in the market.

2008 Jun 11 10:57 AM

[Itsonlymoney:]

I agree with the author that these financial stocks are looking attractive and are paying you to wait while the rest of the market sees the same thing. On the other hand I like to "buy low" and I think the market still has some tricks to play on us regarding financials. PFE is anybody's guess.

Hey danthetaxman, If the market always correctly priced a stock there would be nothing for us to do.

2008 Jun 11 12:05 PM

[bill d:]

I think this was an excellent article. Am basically an options trader but have been selling puts on stocks I want to own anyway that have good dividends - Canroys and soon to be a BAC holder - pretty sure (lol) the Jun 35 puts I sold will be exercised but I will have bought the stock at a discount. Personally I hate BAC as a former customer - was with them for 25 years - customer service got so bad and their record keeping so lame I quit. But they are still the 8 ton gorilla that makes a lot of bananas.

2008 Jun 11 01:01 PM

[mcsisyphus:]

I'm with bill d, playing the put purchase is my preferred purchase. The posiblility of dividend reduction and price decline are the risks that 8% entail. Hate being a customer, love the solidness. BA will be here at the end of the road and we'll be 100% ahead of the game in 2 years.

2008 Jun 12 04:11 PM

[Dan Jacome:]

nice piece, esp the stuff on SBCF

2008 Jun 23 04:05 AM