Sunday, May 14, 2006

Satisfying your Dividend Appetite...Is there Danger in Dividends?

In this weekend's Barron's "Other Voices" section, there is an interesting article entitled "There's Danger in Dividends." (subscription required)

The author, Richard Wiggins, describes the current vogue for dividend paying stocks. His concern is that the dividend strategy has become too popular largely because of the tacit assumptions that investors make when they focus on yield. In the article, he describes that a "dividend - hungry portfolio often will be concentrated in financial and utility stocks, which are extremely sensitive to shifts in inflation and interest rates."

He also describes the nature of the market as a "complex adaptive system," one which mutates and evolves as it goes along, one whose trajectory using previous rules of thumb and strategies cannot be predicted, in short, you can't play last year's strategy for this year's game. As Wiggins describes, "Your edge is dulled as competitors pile onto your strategy; eventually you get crowded out."

It is quite true that well-worn strategies tend to lose their effectiveness, in other words, if everyone is thinking the same, no one is really thinking.

Dividends and yield have always some some place in investment thinking and portfolio selection. After all, a good part of valuation theory in finance is based on dividend discount or dividend growth models. In fact, equity allocations for many insurance portfolios in the 1950's used equities only when equity dividends exceeded the prevailing bond yields. Ultimately, most institutional portfolios accepted the notion of growth both of capital and dividends. The changes in taxation in the US in 2003 lowered the tax on most dividends to 15% thus evoking a major change in investor's thinking as well as corporate behavior. It appears that this treatment will be extended to at least 2010.

Why the special treatment? High dividend taxes reduce the incentive to pay out rather than retain earnings.High dividend taxes create a bias against savings and investment. Finally, high dividend taxes cause corporations to rely more heavily on debt financing rather than equity financing which makes corporations more bankruptcy vulnerable in downturns.

But are dividends becoming too popular as a strategy? Here are the current dividend ETF's:
iShares Dow Jones Select Dividend (DVY)
PowerShares High Yield Equity Dividend Achievers (PEY)
PowerShares Dividend Achievers (PFM)
PowerShares High Growth Rate Dividend Achievers (PHJ)
PowerShares International Dividend Achievers (PID)
State Street SPDR Dividend (SDY)
First Trust Morningstar Dividend Leaders (FDL)
Vanguard Dividend Appreciation Index Vipers (VIG)

There are significant differences among these ETF's. Some have fundamental tests of payout ratios, such as FDL. Others look for Mergent or S&P Dividend Aristocrats characteristics of consistent raising of dividends such as SDY and VIG.

Over the long run, dividends have been an important source of overall returns for stocks. In this working paper by Fama and French, the important role of dividends over time is discussed. Returns are broken down into three components,
  1. the dividend
  2. the growth rate of book equity due to reinvestment, and
  3. the growth rate of the price/book ratio
During 1963-2003, dividends contribute more to the returns on value stocks. But an interesting result is that the higher dividends of value stocks are special to 1963-2003. For 1926-1962 the contribution of dividends to average returns is not systematically different for value and growth stocks. Growth stocks, paying lower dividends tend to have higher reinvestment and consequently, higher growth rates of book equity. However, over time, their price to book ratio declines resulting in lesser relative performance compared to value stocks. Value stocks, on the other hand, tend to enjoy expansion of their price to book ratios over time.

The total market return for the period 1926-2003 was 9.86% of which 3.97% was due to dividends or about 40%, clearly not insignificant. The effect of dividends was particularly strong for large cap value stocks in the pre 1963 period where dividends contributed 4.75% of the total return of 10.46% or 45%. For small cap value stocks, the dividend effect was much less, 3.6% of 11.61% or 31%.

For the post 1963 period, dividends represented 4.76% of 12.67% or 38% of returns for large cap value stocks and 2.94% of 16.69% returns for small cap value stocks or only about 18%. Remember that these studies end in 2003, prior to the effect of tax legislation on corporate and individual behaviors.

Wiggins points to the financial service and utilities sectors as being particularly vulnerable to rising interest rates. No debate here. But financial services stocks in the S&P yield about 2.25% for the XLF, Financial Select SPDRs. The median yield for the sector is a very modest 1.77%, not exactly a comforting level. Utilities, on the other hand, for the XLU Utilities SPDR yield 3.34% but the median yield is significantly higher, at 4.17%.

My conclusions: Two observations that I would note...the lower the aggregate return, the greater the significance of dividends. The higher the market cap, the greater the significance of dividends.

One final thought. Dividend yields are nice but dividend growth is even nicer. Dividend growth is a corollary of improving profitability, improving free cash flow, and improving return on invested capital. Companies which exhibit superior profitability characteristics are often likely to share the wealth with their minority "partners" through dividend growth or buying back of stock. If returns on capital are exceedingly high, the propensity to reinvest and grow the business is also a terrific decision.

Evaluating companies on the basis of yield alone can be dangerous...remember the example of Eastman Kodak which, because of its high yield qualified as a member of the Dogs of the Dow. Dividend cuts will occur as tough corporate economics dictate lower payout ratios.

The significance of dividends will ebb and flow over time as the Fama and French paper suggests. But following a discipline of determining intrinsic value and ensuring that one pays a reasonable discount (margin of safety) to that value will keep you out of trouble.

Disclaimer: I and my family do not currently own any of the ETF's mentioned in this post. One of my clients has a position in SDY.


At 7:20 AM, Blogger NO DooDahs said...

GCI Gannett is a powerful example of dividend growth ...

At 11:55 AM, Blogger Doug said...

I always laugh at the pundits who say that higher interest rates will hurt REITs, utilities and other high-yield stocks.

High interest rates hurt ALL stocks, and, theoretically, hurt non-dividend-paying "growth stocks" the most. If one looks at an equity investment as a bond (with uncertain and sometimes growing coupons) the duration rules are the same. Higher interest rates, lower present value of cash flows. What if the cash flows don't materialize until the future (as oppposed to now, with a high-yield stock)? The PV drops MORE as a function of interest rates. Buying a growth stock is the equivalent of buying a zero-coupon bond, duration-wise.

This is the same reason that junk bonds are less interest-rate sensitive than corporates or treasuries - you get your cash NOW.


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