Rising dividends a profitability litmus test for shareholders
Consistent growth pays dividends especially for those who are prepared to reinvest and wait
STUDIES SHOW THAT THE MORE CASH A COMPANY KEEPS, THE MORE LIKELY IT IS THAT IT WILL OVERPAY FOR ACQUISITIONS
Value Walk tells the story of Russ Gremel, who recently donated $2.1m of Walgreens’ stock to a wildlife refuge, having acquired the shares about 70 years ago for $1,000. Walgreens has kept growing over the years, and by the time Gremel parted with his shares they were generating $42,000 in annual dividend income that’s 42 times their original cost, every year.
Dividend Growth Investor tells of a similar success story this time of Grace Groner, who turned a small, $180 investment in 1935 into $7m by the time of her death in 2010. Groner, who worked as a secretary at Abbott Laboratories for 43 years, invested $180 in three shares of Abbott Laboratories. She then simply reinvested the dividends for the next 75 years.
Both stories rely on two essential ingredients: a company that keeps raising its dividends for years on end, and an investor who’s happy not to sell during this time. But the latter may be the more important of the two, as another tale from Dividend Growth Investor, that of Anne Scheiber, illustrates.
Scheiber turned a $5,000 investment in 1944 into $22m by the time of her death in 1995 not by investing in one company but by accumulating stocks in brand-name companies such as Coca-Cola, PepsiCo, BristolMyers and Schering Plough; companies she understood and in which she reinvested dividends for decades. Scheiber, who did her own research, never sold, even during the 1972-74 bear market and the 1987 market crash, because of her conviction in her picks.
An important investor trait in all three stories is patience. For those who have it, investing in rising dividends is a good bet. A track record of dividend increases is a great way to determine whether a company has true competitive advantages and a durable business model. “Indeed, the most important market strategy is just to reinvest dividends,” wrote Alen Mattich in the Wall Street Journal. “Rising dividends are your profitability litmus test.”
One of the simplest ways for a firm to communicate financial wellbeing is to say the cheque is in the mail. A company’s willingness and ability to pay steady dividends and its power to increase them speak volumes about its fundamentals.
According to Investopedia, “Dividends bring more discipline to management’s investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management and unproductive use of assets. Studies show that the more cash a company keeps, the more likely it is that it will overpay for acquisitions, and thereby damage shareholder value. Companies that pay dividends tend to be more efficient in their use of capital than those that do not.
“Furthermore, companies that pay dividends are less likely to be ‘cooking the books’. Managers can be awfully creative when it comes to making earnings look good. But with dividend obligations to meet twice a year, manipulation becomes that much more challenging.
“Finally, dividends are public promises. Breaking them is both embarrassing and damaging to share prices. To tarry over raising dividends is seen as a confession of failure.”
Whatever message it carries, a company’s dividend policy can’t be ignored. But while it’s intuitive to look at what’s worked in the past, there’ sa danger in relying on outdated trends. Dividends may have been the bedrock of investing. But it would be dangerous to rely on their long history. As far back as 1973, Benjamin Graham warned about how, “Years ago it was typically the weak company that was more or less forced to hold onto its profits, instead of paying out the usual 60% to 75% of them in dividends whereas, nowadays, it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments.”
“If we treated dividends like the polio vaccine,” says the Motley Fool, “we might think we can look at the past, figure out what’s worked, and apply it to today’s market. But dividends change like the flu virus. The dynamos Facebook and Google pay no dividends but are some of the world’s healthiest businesses. High dividends are now the refuge of utility companies and struggling oil pipelines the opposite of how markets operated for most of history.
“And yet, Apple and Microsoft are high dividend payers too. So dividend performance may be telling us far less about future prospects than the long guide of history suggests.”
Any company can manage to pay a dividend, but only the very best can grow distributions over a prolonged period. Those that do should not only outperform the rest of the market, but will likely be less susceptible to market downturns and inflationary economic conditions.
What to look for then in dividend stocks is:
Quality. There is no reason to own a mediocre business when you can own a high-quality business. A business that’s paying out all its income as dividends has no margin of safety.
Safety. Even seasoned investors often make the mistake of buying on dividend yield. A company may be borrowing to pay dividends to prevent its stock taking a tumble, but it can’t go on doing that forever.
Reliability. It’s nice to see a big dividend cheque regularly, but can it be sustained? Invest in businesses that have a history of solid growth. A firm that distributes too much of its earnings will eventually have to rely on increased borrowing and share dilution to grow.
Longevity. If a stock you own reduces its dividend, it is paying you less over time, not more. Companies cut dividends when they either expect business to deteriorate or simply can’t afford to maintain prior levels. When dividends are cut, stock prices typically nosedive as the last investors to have held on for better news leave the sinking ship. According to a study by Ned Davis Research, as a group, companies that cut and eliminate dividends have traditionally underperformed the market.
Diversity. No-one is right all the time. Spreading your investments over multiple stocks reduces the impact of being wrong on any one stock. There is a shortage of dividend stocks that meet the criteria, which makes it easy to overpay for those that do. The lost decade for stocks was caused by investors bidding up stock prices to stratospheric levels, which caused subpar market returns despite fundamentals improving. Some believe we’re at risk of repeating that mistake.