Tags
Avon Products, dividend coverage, dividend snorting, dividend yield, income/dividend bubble, Ponzi, REIT/MLP sector, Supervalu Inc., tax-free compounding
Continued from here.
OK, so what’s wrong with a focus on income/dividends?
– Erm, everything..? I wrote about this recently – a focus on a single investment attribute’s always dangerous, but dividend yield certainly seems the v worst of the bunch to me. Sure, it all starts out innocently enough… You have a little toke on a 4% yield occasionally – feels good! But all too soon, it’s not enough – you end up calling your broker every single day, snorting up 6% yields left and right. But it’s OK, it’s low risk, you still know what you’re doing – not like those other losers… So how come I came across you the other day, twitching on a park bench, scanning the dividend column in the FT, muttering ‘All I need is just one more 9 per-center…‘?
– A ‘good‘ dividend yield can’t save a bad share. I wonder how much money’s been lost by people saying ‘…but hey, it’s got a great dividend…‘? All higher yields mostly seem to offer in a portfolio is a gradual migration into mature and/or declining businesses. And what does that offer in terms of upside?! Even worse, it leaves nowhere to hide when the dividend’s compromised – your income drops, and the share price crashes…
– I looked at Supervalu Inc. (SVU:US) recently, a (perpetual) falling knife too many (value) investors felt compelled to try catch. Many highlighted the sweet 6.6% dividend yield – not so sweet now, with the company recently announcing a suspension of their dividend. See the chart? No, that’s not a 2-for-1 stock split, the stock actually dumped 49% on their news… Reminds me of Avon Products (AVP:US) – the only trace of lipstick left here is a 6.0% yield. But the dividend’s consumed the last 5 years of free cash-flow (ignoring M&A and share repurchase, so net debt’s actually tripled), and now they’ve a new CEO & CFO on board. So how much longer can that dividend last? And even if the dividend survives, by some idiotic miracle, how will that improve AVP’s prospects? Appears investors may lose out either way…
– And the people who fall in love with dividends are generally the very folks who can’t afford those kind of losses. They’re also the people who often seem the most vulnerable (we never hear about low P/E investors being targeted & shafted!). ‘Cos every scumbag (criminal, or simply civil) loves an investor who’s just looking for a steady return..! Let’s just stick to the legal stuff (but the FINRA site‘s fun to read…not that they ever get near the real baddies): Take another look at listed US REIT/MLPs (don’t dare look at the unlisted stuff, you’d throw up!) – how many fund some/all of their dividends out of loans/capital/share issuance? Do that with enough scale & deceit, and you’re more than ready for a Ponzi scheme..!
– Far too often, a high dividend’s presented as low risk & sustainable. In reality, it means share dilution, increased leverage, a return of capital, or simply an impairment of the company’s growth prospects – or all of the above! And shareholders buy into this crap. Sometimes they keep buying more…
OK, we’ve covered the taxation issue, and (various forms of) exploitation, but still many investors just can’t get enough dividends. What other possible reasons can there be? Let’s rip right through these:
– Many investors want/need an income: Really? If you’re gainfully (self-)employed/not retired, what on earth are you doing with the dividends? Spending them, or paying tax & buying equities with the net proceeds?! Sigh, I just can’t help you, mate… But if you really do need spending cash, why the obsession with dividends – perhaps you just like a good shellacking from the tax-man? As I’ve pointed out, he much prefers 20 quid of income than capital gains. Whereas nobody else cares – ask the vicars, ask the tarts…money is money! So if you need some cash, a judicious sale now & again from your portfolio is far more attractive.
– Many investors don’t want to eat into their shares/principal: Again, really?! Are you one of those people who does their monthly budgeting via eight different piggy banks? This is a psychological crutch, or a delusion – I’m not sure which! And it’s so ludicrous, it’s probably quite prevalent… In terms of return (forget taxes for a minute), who really cares whether it comes from dividends or capital growth? It’s your money either way – dividends are not ‘free money‘, or a license to spend them blindly. You should be a) either trying to maximize the compounding of your portfolio, or b) trying to determine an appropriate portfolio withdrawal rate based on actual/estimated total returns.
– We already covered a), while if it’s b), dividends are irrelevant to that decision process. At a minimum, ideally, you want to maintain your portfolio in real terms – this means your withdrawal rate cannot exceed any actual/estimated portfolio return in excess of inflation. So, if you expect/are getting hosed with losses, should you be blindly spending your dividends? No, of course not! And if you’re doing well, you’re just selling off some excess principal. The silliest notion is clinging to X number of shares – look to the (rising) monetary value of your holdings instead.
– A (rising) dividend signals management confidence: What is this, some strange kind of kabuki theatre? Or Kremlin watching? I prefer to pay as little attention as possible to what management says or signals, anyway… Most people learn this eventually in the corporate world – look at what your leaders/HR do, not what they say, sometimes they’re two v different things..! But many somehow neglect to apply this lesson in their investing. There’s far too much corporate spin coming from most management teams – far safer to just focus on the actual results they deliver over time.
– If you still insist on interpreting a company’s prospects via the prism of its dividend, you just might be misleading yourself, or you’ve been forced into it by a management who can’t/won’t communicate clearly with you, the shareholder. Neither bodes well…
– Cash dividends (now) are better than future reinvestment gains: We don’t need to argue about this one – this may v well be true! So why are you investing in this company anyway?! You’re essentially saying this is a mature/low growth company and/or it’s in an industry with poor growth prospects. Surely you can find a better investment? You also seem to be suggesting you don’t trust management so much… Which leads to:
– Low/zero dividends encourage management to waste capital: Again, I don’t necessarily disagree – all too often, management will piss your money away the minute you turn your back. Because every mediocre junior/middle manager quickly realizes empire-building, however petty, is the key to advancement & success. Consider how much they’ve mutated if they ever manage to make it to the top: Mini-Genghis Khans riding into battle with a f**king Blackberry & a hole punch. So if that’s what’s worrying you, again I ask, why are you investing in this company anyway?! There are better companies, and management, out there…
OK, so dividends kinda suck…but what’s the alternative? We’ll take a look in our next dividend post.
Wexboy 
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Stlbeerman – thanks. What really alarms me about some of these dividend payers is that they’re using leverage or even shareholders’ capital to fund some/all of their dividends..! And idiot investors don’t even notice – they treat the entire dividend as income, and soon everybody starts bidding up the shares accordingly. Therefore, nobody notices the continual reduction in the intrinsic value of their principal…until a much later/much more painful date. I guess this is more commonly known as a Ponzi scheme!
I think what you’re saying is that you can take advantage of this – I agree that’s possible. a) The idiot investor has no idea he’s in a bubble, b) the semi-smart investor kinda recognizes the bubble & the greater fool theory – he might get burnt,he might not, and c) the smart investor recognizes it for what it really is, and knows it’s time to be a trader, not an investor, and make a killing.
Michael Platt has some v useful thoughts on this in Schwager’s new book. He chastises himself for not playing the upside of bubbles better (his fundamental opinion interferes too much). The natural temptation of many smart investors is to be contrarian, i.e. play the bubble burst – he points out how tough this can actually be, far better to focus your trading efforts on playing the bubble (obviously with strong stop loss/risk controls).
I absolutely think there’s a dividend/income bubble forming (now in the US, and probably across Europe in the end). Since it easily has a runway of 2-3 years in front of it, it can get a lot bigger/more insane before it runs into trouble. Now I think about that, it’s v tempting, but these days I much prefer to be an investor than a trader. Hmmm….?!
Good Morning Wex,
Another way to make money in the market other than value investing is to buy dividend paying secondaries on stocks that have strong income growth. An example that I just bought this morning is WPZ, which is an MLP that owns increasingly fee based pipelines and other assets. It yields around 6.4 percent at the current price of just under $51.
They just announced a secondary offering a couple days ago, so the price is temporarily depressed. In less than 3 months, they will declare a distribution raising the payout. They are projecting payout increases of around 8 percent over the next 3 years. All the suckers sell when a secondary is announced. That is when I buy. By the time, the distribution is announced, I would say there is an 80-90 percent chance that it is trading around $54. The only way it is not trading at $54 is if the broader market gets killed. You make 6 percent in less than a quarter with minimal risk. Maybe more but probably not much less unless there is a market collapse/collapes in the price of oil.
Anyhow, just trying to show you other ways to make money in the market outside of value investing.
Great – and there’s plenty of those secondary offerings about…they gotta pay for those dividends somehow 😉
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Great set of articles and I mostly agree. A couple contrasting thoughts, however:
1) Not all businesses should retain earnings for growth or buybacks. Sometimes there are just no good growth opportunities, or the company is not in the hands of a value-creating capital-allocator. Dividends can benefit the investor in these cases despite the poor tax treatment. But companies with these characteristics should probably trade at discounts, not the premia they are getting these days.
2) I view dividends as one of the few means by which securities have real value (the other way is if a company is bought entirely). In a world where no stocks ever paid dividends or were bought, their value would be entirely theoretical – since shareholders would never actually experience direct benefit of their ownership. This is much like the venerable “trading sardines” tale (“you can’t actually eat that can of sardines – those are trading sardines”). Some proportion of stocks have to pay dividends and get bought, or else the whole equity market might as well not exist. (Of course, this doesn’t mean one needs them in one’s portfolio.)
3) This point is irrelevant to the individual investor because there is nothing actionable he can do – but wouldn’t it be nice to live in a world where tax policy did not force these discussions of dividend versus buyback on us? Where preferential tax treatment of debt payments did not encourage companies to load up with debt financing versus equity? And give LBO buyers an inherent cost advantage? Where corporate healthcare plans were not tax-advantaged versus individually-procured health insurance? And so on. Oh, for such a world…
Thanks, Olmsted,
1) Yes, that’s my point above – i would be departing companies like that..! If a company was cheap enough, I might consider buying it – but my decision would really be driven by price/margin of safety, rather than a high dividend.
2) is an interesting academic point, but I don’t think it really causes much problem in the real world…plenty of v large & successful companies (& investment companies) out there who don’t pay a dividend!
What do you think of the yield on Drax and it’s low p/e after this mornings tumble ?
df
Sorry, utilities don’t grab my attention much – their underlying can be pretty limited. But sometimes you can buy ’em cheap enough – but at the end of the day, they are mostly bought for dividends so you have to primarily evaluate them based on their financial strength and the level of dividend cover.
Agree dividends received personally are walloped for tax but they do accumulate nicely in a pension fund ( non uk of course ).
Yes, tax-exempt receipt of dividends is clearly the lesser evil. But that implies tax-free receipt of capital gains too, and I think there are other good reasons to argue that still can represent the better option for that type of investor.
You are wrong on this one sir. The problem is you are looking only at stinky dividend stocks. There is an art to finding and timing the purchase of high yield stocks that can be very profitable. Look at the performance and charts since 2008 on the following: AGNC, TWO, PSEC, AT, SDRL, MTGE, if you are lucky and or smart, you can buy stocks like BIP that go from 8 percent yielders to 5 percent yielders because of price appreciation. I think we are going to see the same thing with FIG. It only yields about 5 percent now but when you factor in the year end top off dividend it may be closer to 7 or 8 percent
Buying based on good fundamentals/cheap price always offers good upside, regardless of whether a stock pays dividends – and pretty much everything looks good since 2008. If you own a fund that’s is leveraged up, or is mostly composed of unlisted loans/equity, I see no reason it should trade at a premium.
Re FIG: I didn’t want to speculate on an uncertain top-up dividend at year-end, but I’m definitely hoping for that as a pleasant surprise – if it sucks in more dividend seekers, great! – from my perspective, it will simply confirm the great underlying FIG fundamentals, as I’ve pointed out.
Cheers
Hi Wex
I have two kinds of investing friends. One group fancies themselves as pure value investors. I think you fall squarely in this group. The other group is just trying to make money. From my experience this group handily outperforms the pure value investors.
Wayne Gretzky used to be good at skating where the puck was going to be. A great way to make money is to be where the income investors will be before the stocks actually produce income. For example there is a fertilizer MLPS called RNF that came public last year. If you read the prospectus, you knew that they were going to pay a distribution of over $2. Yet you could buy it at the beginning of this year for $16. Now that they have announced the dividends, the stock is around $30.
In a zero interest rate environment, people will always chase yield over fundamentals. Ther are many ways to profit from this even if they do not meet the definition of value investing.
Dave
RNF? 2011 10 K – Revenues and Net Income have pretty much gone nowhere for 5 years [2011 Rev of $179.9 mio & Net Income of $24.9 mio not much different to 5 year averages of $169.7 mio & $19.0 mio]. Average Free Cash Flow (Net Cash from Operating Activities less net Capex) in the past 3 years has been $22.1 mio*.
So, Market Cap is now at 52.4 times Avg. FCF, and the annual dividend (at an estimated $90-$109 mio) would appear to be 4-5 times larger than Avg. FCF. Yep, that’s gonna work out….
* When I exclude a 2011 $20.1 mio advance from the parent company that was v dubiously included in Net Cash from Operating Activities.
Hi Wex,
You are making my point for me. I am not saying to buy RNF here. That would be dumb. I am saying that if you know a stock is going to declare large dividends and has not declared any yet, you can buy it in anticipation of the yield seekers coming into buy it at much higher prices (as here).
Straight value investing (low price, good fundamentals) is one club in an investor’s golf bag. if you bought RNF at the beginning of the year – even though it was not a screaming buy fundamentally at that time – you could still make a lot of money but selling it later on in the year when the income became apparent.
I think you will agree with me that many people buy stocks based on income. I think you will further agree with me that people will pay more for income expressed in dividends (lke MLPs, BDS) than earnings not paid out in income. This because people can understand that they are getting an 8 percent yield and will pay up for that yield. They are less inclined to pay for earnings not expressed as a yield.
My point is that there are lots of ways to make money other than buying the best value investment and in fact, sometimes value investing does not work as the cheap stock can stay cheap or even get cheaper.
Keep up the good work