Real Men and Women Want Dividends

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Real Men (and Women) Want Dividends

• Houston Investors Association
• Getting Started SIG
• 10 November 2007
• Leigh Anderson

Copy of presentation is at www.tayara.com/hia
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How to get rich in the stock market 2 views

• Will Rogers
• buy some good stock and hold it till it goes
  up, then sell it. If it dont go up, dont buy
  it.
• John Burr Williams, The Theory of Investment
  Value, 1938
• A cow for her milk, a hen for her eggs,
• And a stock, by heck, for her dividends.
• An orchard for fruit, bees for their honey,
• And stocks, besides, for their dividends.

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Todays Investing Challenge

• Tougher than it used to be in the good old days
  (1982-2000)
• More competition trillion dollars of hedge fund
  money chasing quick gains
• Excessive focus on short-term (quarterly)
  earnings
• Lower Investment Expectations for Future
• Return Dividend Yield Earnings growth
  Change in P/E
• Dividend Yields are at historic lows
• Earnings (long term) is limited by economy most
  stocks about 6/year
• P/E is already at historic highs unlikely to go
  up likely to go down
• Implication Future returns on stocks will be
  lower
• A different approach
• Dividends do and should make a large part of
  equity returns
• Dividends contain critical information about the
  company its stock
• Let the masses pursue short-term gains and
  concentrate on long-term winners

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Why Focus on Dividends?

• Why is a share of stock worth anything at all?
• Not earnings you cant spend the earnings a
  company retains
• Not the book value you cant sell its assets
• Only 4 ways a share of stock can pay off
• Company liquidates and makes a one-time cash
  payout
• Company is acquired pays cash or stock of
  acquirer
• It pays you a dividend
• You sell it to someone else for more than you
  paid
• But why would someone buy a stock for more than
  you paid?
• The only reason someone (intelligent) will buy
  your share is if it either pays a dividend now,
  or if it will pay a dividend in the future.
• The stream of future dividends (or the promise of
  it) is the reason that a share of stock has value
• Anything else is just financial musical chairs

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Dividends in Long-Term Investing

• From 1871 through 2003, 97 of total real (after
  inflation) accumulation from stocks came from
  dividends.
• Only 3 came from capital gains.
• 1000 invested in stocks in 1871 would have
  accumulated to 8 million (after inflation)
• but only to 240,000 without reinvesting
  dividends.
• Reinvestment of Dividends is crucial
• Over the 122 years, 90,000 in dividends
  collected but with reinvestment, accumulate to
  millions
• If you are planning to hold stock 2 years or
  longer, dividends become an increasingly larger
  part of your returns

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Example National City Bank

• Bought 100 shares of NCC at end of 1995 for
  16.56/share.
• In 10 years following (2005), share price doubled
  to 33.57/share
• Annual capital gain 7.4/year.
• Only matches SP500 price index over same period.
  No big deal.
• But NCC paid dividend averaging 3.9 over this
  period. SP only paid 1.6
• Total return Dividend Yield Capital Gain
• NCC 7.4 3.9 11.3
• SP 7.4 1.6 9.1
• Original 1656 investment grew to 4843 (gain of
  3187), 876 more than SP
• Nearly half the total gain (1465) came from
  reinvested dividends.
• NCC beat the SP by 2.2, with MUCH less heart
  burn
• The longer the investment horizon, the more
  important dividend income becomes
• For long-term investors, the value of the
  portfolio corresponds closely to the present
  value of dividends
• The present value of capital appreciation
  dwindles in significance
• Total return ? Dividend Yield Dividend Growth

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Advantages of Dividend Investing for Individuals

• Easier to forecast dividends than earnings or
  future P/E
• Receive benefits while you own the stock (even in
  a down market), not just when you sell
• Dividends are usually reliable easier to sleep
  at night
• Firms try to keep dividends constant or growing
  they hate to lower or skip dividend payments
• Other investors are obsessed with short-term
  earnings you profit from fads and mood swings

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Dividends Encourage Good Corporate Behavior

• Dividends are paid from the real cash flow of
  the company cant be faked
• Dividends indicate a shareholder-friendly
  management, willing to share profits with
  shareholders
• Dividends take money out of corporate treasuries
  cant be used for wasteful projects,
  over-priced acquisitions, or management excess
• Journal of Finance Cash-rich firms destroy
  seven cents in value for every dollar of cash
  reserves held
• The ONE exception Warren Buffett / Berkshire
  Hathaway

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Finding Attractive Dividend Investment
Opportunities

• Not just picking the highest-yielding stock
• Must establish safety of current dividend and
  estimate growth potential
• Growth is not a given, nor is it free

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The Dividend Drill (Morningstar)

• 1 Calculate Dividend Yield
• 2 Estimate Core Growth
• 3 Estimate the Cost of Growth
• 4 Estimate Surplus Earnings
• 5 Adjust for Share Shrink (buy backs)
• Illustrate with and example of US Bancorp (USB)
  in November 2005

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1 Calculate Dividend Yield

• Dividend Yield Indicated dividend rate / Share
  Price
• USB 0.40/quarter ? 1.60/year
• Stock price 35
• Div Yield 1.6/35 4.6

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2 Estimate Core Growth

• Need Some Yard Sticks
• Companys historical growth rate
• Sustainable growth rate (from financial theory)
• SGR Return on Equity x (1 Payout Ratio)
• Mark to GDP (circa 6/year)
• Very hard for established companies to grow
  faster than the economy
• Often grow slower, because of size and maturity
  of industry
• For USB, assume 5
• Within norms of historical rate and sustainable
  rate

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3 Estimate Cost of Growth

• Growth is not free
• Requires capital, either borrowed or reinvested
  from earnings
• Cost of Growth (dollars per share) Core Growth
  Rate / ROE x EPS
• Note if growth rate exceeds Return on Equity,
  cost exceeds earnings and company is DESTROYING
  value by growing.
• USB Cost of Growth
• 5 growth / 24 ROE x 2.78 EPS 0.58
• Comfortably less than EPS

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4 Estimate Surplus Earnings

• Surplus Earnings EPS Dividend Cost of
  Growth
• What is left over after accounting for dividends
  paid out and cost of growth
• 3 uses for surplus earnings
• Acquisitions of other companies (usually not so
  good)
• Improving the balance sheet by debt reduction
  (good)
• Share buybacks (very good, if shares undervalued)
• USB
• 2.78 EPS - 1.60 Div - 0.58 Cost of Growth
  0.60 Surplus Earnings

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5 Adjusting for Share Shrink

• Share buybacks can boost total returns
  significantly
• (Potential) Share Shrink Surplus Earnings per
  share / Stock Price
• USB
• Share Shrink 0.60 / 35 1.7
• USB seems to be buying back shares
• Add this directly to estimate of total return

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USB Bottom Line

• Total Return Div Yield Core Growth Rate
  Share Shrink
• 4.6 5 1.7 11.3
• 11.3 is a VERY respectable return in todays
  market, and that from a conservative regional
  bank!
• Reality Check
• Today, USB is caught up in the credit panic.
  Stock is trading at 31.
• But so far no evidence of subprime or CDO
  meltdown
• Dividend Yield is now up to 5.2
• PS Warren Buffett is said to be buying

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Payouts in Peril

• Stocks are not bonds, and dividends are not
  guaranteed!
• Six signs that dividends might not be safe
• Its a no-moat company or its moat is drying up
• An established string of dividend increases just
  came to a halt
• Its the highest-yielding stock in its industry
• Payout ratio above 80 of earnings
• (and not a REIT)
• Company has a lot of debt (over 50 of total
  capital)
• Major event risks on the horizon (patent
  expirations, law suits, etc)

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Types of Dividends

• Cash Dividends the normal case
• Return of Capital Not really a dividend a
  partial liquidation of the company
• Stock Dividends a disguised split neither
  increases or diminishes value a non-event
• Special Dividends one-time event
• Qualified Dividends 15 tax rate (currently)
• Non-qualified Taxed at your marginal rate
• REIT dividends are non-qualified hold in an IRA
• Foreign Stocks watch out for loss of foreign tax
  credit in IRAs
• Master Limited Partnerships Complicated tax
  filing. Do NOT hold in an IRA!
• Royalty Trusts Unstable cash flow, finite
  liquidating businesses
• Convertible/Preferred Dividends another subject
  entirely

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Summary

• Dividends are a (the) major source of return
  for long-term investors
• It is relatively easy to identify favorable
  dividend investment opportunities
• Dividend oriented investing provides attractive
  return at lower risk and greater peace of mind

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References for this presentation

• DividendInvestor Strategy newsletter,
  Morningstar.comhttp//www.morningstar.com/product
  s/Newsletters.htmlMDI(99/year)
• The Future for Investors, Jeremy J. Siegel,
  2005
• http//www.amazon.com/Future-Investors-Tried-True-
  Triumph/dp/140008198X

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Book Shelf

• The Future for Investors, Jeremy J. Siegel,
  2005
• http//www.amazon.com/Future-Investors-Tried-True-
  Triumph/dp/140008198X
• Siegel is prof. at Wharton, also author of
  Stocks for the Long Run
• Good book for beginning investors
• Topics
• Subtitled Why the tried and true triumph over
  the bold and new
• Uncovering the Growth Trap how growth
  companies are often poor investments
• Overcoming the Very New examines the bias for
  the new thing and how it leads to investing
  failure
• Sources of Shareholder Value Siegels study of
  role of dividends and advantages of boring
  old companies
• Aging Crisis and Coming Shift of Economic Power
  demographic economic trends
• Portfolio Strategies how to use the dividend
  insight to build robust successful portfolios