Understanding Dividend Policy: Consider Yield and Solid Evidence of R&D

Includes: INTC, MDLZ, MSFT, TM
by: Michael L. Boyer

I bought my first stock in 1992, taking a small inheritance in a brown paper bag down to the Dean Witter office down the street.

I picked Harley Davidson (NYSE:HOG) (which soared before I sold) partly because I could not even buy a new one at the local dealer due to demand (my first experience with Phil Fisher's "scuttlebutt" paid off). And as a Chevy guy, I also picked GM because I did not really know of many companies at the time. It was not a great pick or strategy, but it sent me regular checks in the mail -- something that seemed like mysterious manna from corporate heaven at the time.

Now fast forward 20 years. After hundreds of investment books, a couple thousand hours of CNBC and even some painful graduate finance courses, the mystery of corporate dividends has begun to slowly unravel but still presents some mystery. Today, I like for firms with a balanced dividend policy: those offering cash today but solid R&D for tomorrow.

How to decipher dividend policy? First, there is the easy to understand dividend truisms that we all know about. Young growth companies should plow all their retained earnings back into the firm, opening new stores, expanding into new territories and creating new products. Established, mature firms, however, should share the wealth with shareholders.

Those of us with a few decades in the market have even seen the cycle and watched some former youthful, high fliers like Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) turn into mature, steady dividend payers (they've tuned into stable middle-aged creatures like us).

At second glance, dividend policy becomes more complex and nuanced -- especially as we see even market experts can disagree on the best use of retained earnings. Let's get murky.

Warren Buffett's clearly stated beliefs on dividends can be found in his Berkshire Hathaway (BRK.A, BRK.B) annual reports and in the many books about him and his philosophy. Buffett's thesis is that the best use of retained earnings is to plow the money back into the firm, investing in new businesses or buying back stock, to achieve long term, compounding with high returns on equity.

Buffett is clearly on one end of the spectrum in not favoring a dividend at all (unless, of course, shareholders can get a better return on the money in another available investment). But the problems of double taxation -- even though eased under current rules -- with dividends still exist with earnings taxed at both the corporate and shareholder level. In addition, the shareholder often faces a reinvestment dilemma in finding an equivalent investment along with accompanying transaction costs.

However, another cogent market observer and stock market scholar -- Jeremy Siegel -- has made a very credible argument in his books that dividends are a key reason why stocks have outperformed other investments over the last two hundred years. Moreover, today many investors hold stocks in tax deferred accounts (401K, 403b, IRA, or even tax free in the Roth IRA) and many investors utilize DRIPs (dividend reinvestment) featured by most brokers, essentially allowing for the same plowback principle to take place.

Of course, our feelings about dividends are also shaped by the tandem disasters of the tech bubble and the 2000 era scandals (e.g., Enron, WorldCom). Lofty projections and off-sheet partnerships turned into ethereal mist., whereas cold, hard cash dividends could not easily be faked. Regular dividends also create a self-imposed discipline on firms making them accountable for regular cash payments and leaving less money for poorly managed firms to squander.

Dividends present a perennial financial management puzzle that revolves around the use of retained earnings. How companies set their policies and the percentage of retained earnings apportioned for dividends has become especially important with low record interest rates leaving investors seeking returns.

The increased attention and demand for dividends payouts, however, should not obscure equally compelling demands faced by firms. Consider a key theme in the 1950's classic by Phil Fisher, Common Stocks, Uncommon Profits: Strong research and development leads to long term profits. Fisher foresaw the key role of research and development and also the necessity of building a sales force.

On the razor's edge of dividend policy, companies and their leaders must balance the competing demands for long term R&D and immediate payout for shareholders. In the philosophical long game of dividend policy, the management takes the snap and calls the plays.

Dividends force us to look at whether we can entrust the retained earnings of the company to its leaders (who ideally invest and compound these earnings) or transfer the retained earnings back to shareholders who either need the income or can get a better return elsewhere.

Both the dividend yield and percentage of retained earnings a firm pays out have become key metrics investors look at today. However, except for companies like REITs, pipelines, and commodity-centered firms, most companies need to balance the payout to shareholders with other interests--particularly R&D.

Looking at yield along side research and development (R&D) spending is a rough means to capture how well a company can balance the demand for a current dividend with the long view of creating value for the future. Strong research and development expenditures relative to revenues coupled with a solid yield can signal a balanced dividend policy. Of course, the R&D must be properly managed and executed, and successful firms also have a record of successful research.

At the eve of my 20th year anniversary with stocks, I now look for both yield and solid evidence of R&D to boost future share values - a promise of payment now as well future share appreciation.

KFT: Dividend yield 3.4%. R&D closing on 10% of revenues. While we normally think of Oreos and Wheat Thins as low technology, nothing could further from the truth. Kraft has 6 research facilities across the globe, constantly testing new baking technologies and producing successful variations on their solid brand themes. With 8% of 2010 revenues going into new product development and 10% slated for 2013, Kraft could be boosting the product pipeline. Kraft also throws another 10% of revenues at building brands through marketing that can boost current and future sales. These traits are likely to be passed on to one or both of the two future companies as this organization divides itself by year-end.

MSFT: Dividend yield 2.5%. R&D 14.6% of revenues. Lately, MSFT appears to be focused on buying and not creating innovations, but with a huge war chest, the firm can afford to do both. There seems to be a renewed focus on cloud and mobile devices related R&D. MSFT leaves many tech firms in the dust in R&D while still offering a solid dividend.

INTC: Dividend yield 4.1%; R&D 16% of revenues. Even though Intel has taken some flack for leadership in the slow but steady PC chip market, the firm is a perennial global leader among patent producers in the world, setting the stage for the future products and services.

TM: Dividend yield 1.3%; R&D Up to 5% of revenues. The Toyota Way popularized many quality management innovations. Today it is the world leader in R&D expenditures. The continuous improvement in mileage, quality, safety features, as well as electric and hybrid aspects will be key for future acceleration at the automaker. Toyota has been putting cash into R&D--between $8-9 billion annually. It should be well ahead of the curve on future trends. A strong cash position could also lead to an increased dividend as the aftershocks of earthquake supply chain disruptions pass.

Drug stocks: Ponzio has outlined the relative strengths of pharmaceutical firms R&D as percentage of revenues in an earlier article.

Note: Yield is as of 8/13/2011; R&D from most recent information available on the internet.

Disclosure: I am long KFT. I own all others mentioned through various index and mutual funds. Related party has long position in MSFT.

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