Smart Dividend Investing: Beyond Yield
In a zero interest rate world, where liquidity and a newfound (recently rediscovered?) religion that credit defaults will be few and far between, assets with yield have been steadily bid up. The result: just as short-term savings accounts offer almost nothing in the way of interest, risk assets have seen spreads (the difference between their yield and a risk-free proxy) squeezed, so that they look much less attractive.
If you’re a bond manager, the trade-off between yield and safety is fairly apparent; moving up in one requires sacrificing some of the other. But equity investors, for some reason, often overlook that the “free lunch” to be had in dividend investing isn’t as great as it might appear, which is why having a good dividend stock screen is so important to narrow down candidates. Once a starting point is established, here are a few more analytical steps to take:
-Funding the dividend
The dividend culture that exists among investors encourages some management teams to (wrongly) believe that they need to pay a dividend in order to gain some perception of stability or conservatism. But a dividend, like water, is only as good as the source it comes from. Borrowing extra money to continue paying distributions to shareholders is something easily detected by looking at a firm’s Statement of Cash Flows, and a look at the Income Statement can tell if the dividend is an extremely high percentage of earnings. Either situation says that the firm likely is not profitable enough at present to be paying a dividend, which leads us to…
-Distributing excess capital
Some mature firms (many consumer staples come to mind) have limited expansion opportunities but are highly profitable; it makes sense for these companies to distribute such “excess capital” to investors if it would otherwise result in a large cash build-up on the balance sheet. It doesn’t make sense for companies to pay a dividend while simultaneously undergoing an aggressive expansion or trying to maintain certain standards of financial conservativism. Banks are a classic example of the latter; Citigroup (C) and Bank of America (BAC) each paid about $10 billion annually in dividends during the “good times” leading up to the crash. That money, of course, would have been extraordinarily valuable if it were retained. Looking at whether a company is actually giving investors back capital that it can’t make good use of, as opposed to simply increasing leverage (the effective side-effect of dividends), requires more analysis, which should culminate in…
-Estimating a sustainable yield
I’ve seen many people mistake a short-term anomalous yield for a supposedly-good dividend investment. Always check to see if the payout and yield are correct, or if they’re being skewed by a short-term event such as a special payout or variable profits. Common sense reigns here; if something is advertised as having a 15% yield, that should raise eyebrows, since most companies don’t have either the cash flow generating power (#1) or excess capital (#2) to consistently pay out that much.
Bank Bailout Report Card: What Are We Grading?
Earlier this week, I gave a presentation on Merrill Lynch, the differences between it and other investment banks, and why Bank of America’s (BAC) acquisition of the company in its dying days of September 2008 was not necessarily a bad idea. While a tough position to argue on its face, there are actually many reasons justifying such a deal – combining an unstable investment bank with a depository institution is effectively what the Federal Reserve did the next week in allowing Morgan Stanley (MS) and Goldman Sachs (GS) to become bank holding companies, for example. In the short-term, however, a world of rising credit losses will make any deal of that type look to be a poor move, however. Yet basing a decision purely on hindsight-rich outcome is analogous to saying an energy E&P company is poorly run if they start drilling new wells only to see crude prices fall.
Why do I say this? Perspectives can shift quickly, and create unfair comparisons when time horizons or end goals differ. With the bankruptcy filing of CIT Group (CIT), the government is opening itself to questions about the effectiveness of TARP, as the $2.3 billion preferred investment in CIT is in great jeopardy. The purpose of TARP, however, was not to maximize the government’s return on investment; it was to stabilize the financial system (using kind words) or save it from collapse (more bluntly) with a minimum of losses. TARP was a large check the government had to write to buy time, and it definitely succeeded in accomplishing that.
In the last month, I’ve been asked numerous times for thoughts on the financial crisis fallout, having had a year to reflect and see how things have played out. The simple fact that we’re having discussions about the banking system a year later means that TARP achieved its purpose, and the bankruptcy of a relatively smaller financing company like CIT Group doesn’t seem to change that. With the benefit of extra time to assess the choices of the Treasury Department, alternative solutions could surely have been devised that would have rewarded the U.S. government more – but again, that was not the purpose. Though I feel TARP was a good first step toward stemming the crisis of confidence that (rightly or wrongly) gripped the markets in the fall of 2008, the lack of follow-through to reforming the financial system and minimizing future systemic risks is a disappointment. That, however, is a knock against the politicalization of everything Wall Street that came afterwards, not TARP itself.