Dividends Don't Lie
This month I’d like to discuss dividends. I’ll highlight a few stats that Swiss Bank UBS put out in a recent riveting 50-page report titled “Safe dividends in times of financial repression.” Before that, though, let’s briefly go over some dividend basics and our team’s recent thinking on dividend payers. I should also point out that Zach writes on one dividend-heavy sector for our managed accounts, real estate, later in this newsletter.
First, the Basics
A dividend is simply a shareholder distribution that a company makes from a portion of its earnings. Management teams and board directors have a myriad of options when it comes to utilizing a firm’s profits. They can reinvest these earnings back into the company, make acquisitions, reduce debt, buy back stock or pay investors a dividend. Most earnings-generating companies do some combination of these things, and many include dividends as part of the mix. Some set a transparent policy for shareholders (for example, targeting a stable absolute dividend or a target payout ratio of earnings), while others choose to stay less committed and offer only the occasional “special” dividend.
For investors, total returns on a stock are simply a combination of any dividends received and price appreciation over a given holding period. If a stock is foreign, changes in exchange rates can add or subtract from the U.S.$ dividends and price gains. Because the price appreciation portion of total return often depends as much on the sentiment and motivations of other investors as it does on a company’s fundamentals, many investors (like us, especially in our strategies geared for clients with regular portfolio cash needs) prefer to own stocks where a meaningful part of the expected return is projected to come from dividends.
In fact, nearly all of the stocks held in our Balanced Conservative and Yield Income strategies pay dividends. This steady stream of dividends can be a real help during periods of general market stress as it allows us to avoid selling positions to meet cash needs when market prices are irrationally low. The annual yields that our dividend payers produce (in combination with the yields from the bond investments held in these portfolios) are expected to cover most of the 3%-6% sustainable withdrawal rates we advise for clients in these strategies.
Dividends Don’t Lie (But Watch Out for Sucker Yields)
The old Wall Street saying, “dividends don’t lie” has often been cited by dividend-loving investors. There was even a book written back in 1990 by Geraldine Weiss and Janet Lowe titled Dividends Don’t Lie: Finding Value in Blue-Chip Stocks. Cash dividends, unlike accounting earnings, are pretty much impossible to fake, although they can certainly prove to be unsustainable. Remember that the fundamental value of a stock can be simplified down to the company’s expected future stream of dividends (discounted back to today’s dollars). In most cases, the majority of a company’s fundamental value comes from expected dividends years and even decades into the future. Losing sight of this and focusing only a tantalizing dividend yield based on current dividends, can lead to ugly “sucker yield” outcomes should dividends end up being reduced or eliminated because of weakness in a company’s cash generation capability.
Our investment team spends significant time analyzing the sustainability of dividends in our portfolio companies. We look at a broad array of drivers behind the cash flows that ultimately support a dividend payment. These drivers encompass most of a company’s “funda-mentals,” including its business model, competitive position, management team and balance sheet strength.
Our analysis of dividend stocks (and all stocks for that matter) also looks hard at valuation. It is one thing to find a solid dividend-paying company and quite another to find an attractively priced dividend-paying stock. This is especially so after years of exceptionally low interest rates that have forced conservative investors to leave the comfort of bond-land to find the yield they seek elsewhere. As the herd has crowded into “blue chip” dividend-paying stocks, the prices of these stocks has risen considerably, leaving many such stocks vulnerable to any change in investor sentiment.
Taking Advantage of Short-Term Mood Swings
Fortunately, our team has the flexibility to invest globally and across a variety of sectors and company sizes. Lately, we continue to find good values in select dividend-paying stocks both here and abroad. By staying focused on long-term fundamentals, we can exploit short-term changes in investor sentiment. For example, we continue to find excellent value in Europe as concerns of Greece’s future in the Eurozone weaken investor appetite for Europe-listed shares. We are also finding certain stocks deemed “bond-like” or “interest rate-sensitive” in areas like utilities and real estate quite interesting of late, as they tend to trade cheaper when investors get nervous about the prospect for higher interest rates. We are comfortable holding these high current dividend/modest future dividend growth names as part of the portfolio mix given our belief that global economies will stay sluggish at best and that the deflationary pressure from longer-term global trends in debt and demographics will keep a lid on interest rates for the foreseeable future.
Looking ahead, we expect that investor demand for dividends will remain strong. As Baby Boomers continue to enter retirement, they will likely desire more of the “bird in the hand” that dividends offer versus the much less certain “two in the bush” potential of non-dividend payers. This will especially be the case if large parts of the bond market continue to offer far more risk than reward (negative yields after inflation and significant loss potential should rates normalize). Key for our team’s success will be our disciplined analysis of dividend sustainability and our willingness to exploit the temporary shifts in sentiment that drive market prices apart from fundamental value.
In closing, I’ll share just a few snippets from the UBS report that gives statistical support to dividend-loving investment approaches. The Swiss Bank looked at total returns at the 1,000 largest U.S. companies from 1974-2014. The combined annual return for the 1,000 companies that paid dividends was 3.2% higher for the dividend payers and 4.2% greater than the non: dividend paying equites over that 40 year period.
The study also found consistent outperformance for the high-dividend yield group through the 40-year period, especially over longer holding periods. As Figure 1 shows, for 10-year holding periods, the high dividend yield subset outperformed the market nearly 90% of the time, while the no dividend group outperformed only 20% of the time. While the often repeated disclaimer that past performance is not indicative of future returns should always be heeded, we believe there is good potential for the continued outperformance of dividend payers into the future. We expect that high-quality dividend payers will remain a significant part of our portfolio mix.
What is risk to a professional investor? It depends on the seat the investor occupies. When I was at BlackRock managing a Large Cap Growth fund, my risk was always versus a benchmark. Specifically, my job was to consistently beat the Russell 1000 Large Cap Growth benchmark on a 1-, 3- and 5-year basis. That seemed like a noble goal, but it was not always aligned with the long-term goals of the average investor and sometimes was actually fraught with considerable risk. At BlackRock, absolute return was not a consideration; we concerned ourselves only with relative returns. Whether my portfolio was up 50% or down 50%, BlackRock management and many of my institutional investors were not concerned as long as I beat the benchmark.
This focus on the benchmark often led to herding behavior and an actual hidden increase in risk from an absolute return standpoint. For example, at the height of the tech bubble in 2000, the technology sector was about 65% of the benchmark. Believe it or not, the way the risk was defined, it was considered risky not to have a full weighting to the benchmark in technology stocks. Suppose in 2000 I felt that technology stocks were going to implode and I went to a zero weighting in sector. Well, the risk police of the firm would flag me and want to have a chat about the risk I was taking for my clients and the firm by making such a bold bet. The firm did not care that tech stocks were trading at 100 P/Es or that it was 65% of my portfolio because it was too much risk to take versus the benchmark. And herein lies the distortion. Risk to much of Wall Street is relative, not absolute. At the end of the Bull Market in the 1990s, everyone owned tech stocks because they were perceived as “not risky.” The risk models that Wall Street uses are static and not forward-looking.
Today, we see history repeating itself. If you manage a Large Cap Growth portfolio today, Apple is 7.00% of your benchmark and has a market cap of $750 billion. Clearly Apple is an amazing company and has been a fantastic stock. Everyone owns it because, by Wall Street’s measures, it is a risky stock not to own. However, how does it look on an absolute return out five years? I would argue that we have seen most of Apple’s best days. When I look to the future I see slowing growth as smartphone penetration looks to have peaked this year globally. Margins are at peak and competition will intensify. Never in the history of consumer electronics has a company been able to keep margins sustainably high for more than a few years. Granted Apple has lasted longer than most, but the mobile phone business is brutally competitive. To put Apple’s stock into perspective, the market cap is currently larger than the entire market cap of the Russian stock market. In the dot-com bubble we saw similar comparisons … and we all know how those returns looked five years out.
In the vein oflooking forward, certain Russian stocks have presented a unique opportunity for the patient investor with the ability to withstand some short-term volatility. Russia is in the midst of a deep recession due to E.U. and U.S. sanctions. One stock that we have purchased in Russia is Yandex (YNDX), the Russian equivalent of Google with 60% market share and sizable growth prospects. Last year, the stock was trading at a high of $45, and we have been able to purchase it for $16. The company has a market cap of $5 billion and a normalized three- to five-year growth rate of 25%. Due to the recession, growth has slowed and valuation of the stock now trades at a significant discount to its long-term growth rate. If I look out three years, this stock can definitely get back to $45 and likely exceed these levels as Internet penetration and e-commerce are much lower than in the developed world, giving a growth runway for years to come. The sanity check is simply this: does a $5 billion market cap seem excessive for a search engine with 160 million Russian-speaking people as a market? To me the answer is simply “no.”
Currently Mr. Market loves Apple because it is too risky not to own even though the price is at a high and its prospects are as well. Mr. Market hates Russia and Yandex, and it’s too risky to own even though prices are much lower than a year ago. The way the sausage is made on Wall Street is definitely strange and sometimes insane. I like the way we do things at FIM Group and is one of the major reasons I joined the firm.