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I read something utterly fascinating about dividends
last week. "A share's value," wrote The Economist, "must be
the present value of all future dividends."
Is this true?
Maybe, maybe not. Let's consider it. We'll borrow an
example from the headlines and look at General Electric
(NYSE: GE),
which recently cut its dividend for the first time in more
than 70 years. We'll evaluate GE from the perspective of a
conservative, long-term income investor.
The shares, priced at roughly $9, now pay a dime each quarter.
That's a 4.4% yield, about a point ahead of the broader S&P's
average yield.
By The Economist's reckoning, the only upside for
these shares would occur after 17 years of GE ownership,
when an investor would have recouped the initial cost of the
shares through dividends. At that point, the shares would
have paid for themselves and any additional cash flow from
them would be gravy.
That's one way of looking at it.
But that valuation model excludes some critical facts,
and not least among them is a company's ability to deliver
long-term results. In GE's case, the conglomerate is
typically the No. 1 or No. 2 competitor in every field in
which it does business, and this domination is evident in
the bottom line. "You're talking (about a company)," GE
chief Jeffrey Immelt said March 5th, "that earned $18 billion
last year on $183 billion in revenue, that's outperformed
the S&P 500 from a revenue and earnings standpoint over the
last five years."
Or, to put an even finer point on it, a profitable and
highly rated company that's worth an average 17.2 times
earnings but whose P/E has slipped to an anemic 4.6.
Was what The Economist wrote wrong?
Not necessarily. The article's point may be considered
by-the-book accurate, and taken as a whole the reporting and
analysis in the piece were well done. But the
statement above might not be the whole truth. In my
view, this characterization of stock prices and dividends
omits a critical qualifier. Were I an editor of that
esteemed publication, I'd have suggested the sentence be
recast to read, "A share's price represents the
market's view of the present value of all future
dividends as well as its collective judgment about its
current prospects."
It is, after all, the market that decides what a stock
is worth. And markets, made up as they are of millions of
frantic individual investors, are not functioning in a
logical way. All one needs to prove that point is to look
at the CBOE's Volatility Index, which, at 45, remains leaps
and bounds above its 200-day moving average. Markets are not
simply responding to dividend payout levels: They hinge as
they always do on a variety of factors, fundamental,
technical and, most importantly, psychological.
Now, a manic market does not mean that there aren't
ways for income investors to make money -- it only changes
the nature of those opportunities. That's why it is a good
idea to be reminded of what dividends mean.
Dividends are more than a simple cash payment to
shareholders. They are a symbol of strength and stability of
both the company and the economy it operates it. As
confidence has eroded in the economy and in some specific
sectors like finance, stock prices have plummeted across the
board. As the business climate has depressed results, so too
has the willingness of companies to part with cash.
The Economist was dead-on in its assessment of this
reality: "There is no point in starving a business and
endangering a firm's balance sheet in order to meet macho
dividend commitments."
In other words, would you rather have a dividend cut or
a business that can no longer continue as a going concern?
Do you want a bird in the hand if it means decimating the
bush?
The publication continued: "...[I]n theory, shareholders
should not care whether dividends are paid out today or
later. Just as taking money out of a cash machine does not
make you richer, nor does extracting cash from a firm you
own."
The point to remember is that the a company's cash
belongs to its shareholders whether it is put to work
rebuilding the balance sheet or sent to you in the form of a
dividend check. A prudent investor may well opt for a lesser
result to insure the enterprise's long-term success. This
works financially as well as medically: If doctors must
re-break a bone in order to set it properly, it will grown
back as strong as it was. If it is left to grow back on its
own, it may never regain its former ability.
With that in mind, let's return to our consideration of
GE, which is probably as good a proxy for blue-chip dividend
payers as any. If we assume that an investor can
purchase shares and hold them for 10 years, and we further
assume that GE can achieve a +15% annual growth in its share
price -- slightly ahead of the long-term average for the S&P
500 -- then the value of those shares goes from $9 to
$36.40. Assuming that the results are scalable, the dividend
would also rise from a dime to $0.35. That's more than a
15.6% yield on your initial invested capital to say nothing
of a capital gain of +304.6%.
Market signals overall are tough to read and volatility
is high. When the market stops making sense, as I have
written before, then it is time to stop trying to make sense
of the market. We have all taken trips where the road seemed
treacherous for a while, only to become straighter and
smoother as the miles progresses. The trick in these
situations is to focus not on the road but on the car.
The stock price represents the market's perception of
the value of future dividends and all future business
results (which may not be reflected in dividends for some
time as companies prudently conserve cash). That view is
less than rosy; some payouts are being cut. That course will
reverse. Some measure of logic will return to the market's
valuation; mania and volatility always fade. For investors
willing to exercise patience -- and to commit to collect
their returns over time -- the current market opportunities
offer the deal of a lifetime.
Many happy returns!
--Andy Obermueller
Co-Editor
Global Dividend Opportunities
GlobalDividends.com
839-K Quince Orchard Blvd.
Gaithersburg, MD 20878-1614
P.S.
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