Friday, June 15, 2007

Dividends Talk

By Greg Donaldson and Mike Hull If you listen very closely, you will find that dividends talk. Indeed, they speak in the universal language of money on the barrel head, not in the wink-and-a-nod dialect of earnings or price. Twenty years ago we began a search for a way to determine the intrinsic value of a stock. For approximately 25% of the S&P 500, we believe we have found it -- listening to the dividends. They talk. Not very much and not very often, but watching their trends over about any 5-year time frame can offer a very good idea of what a stock is worth if you have the right tools. If you include interest rates and, in some cases, earnings, the picture becomes clearer. For the 12 months ending May 31, our Rising Dividend--Cornerstone investment style has experienced the best 12-month dividend growth we can remember, nearly 12.5%. During this time, its dividend yield averaged about 3.25%. If you add the two numbers together, you get 15.75%. That is what we call the Total Dividend Return(TDR). Our dividend theory(and what we believe our Dividend Valuation Models show) is that over the long-term, the total return(price appreciation + dividends) of most consistent dividend payers will approximate its Total Dividend Return. Thus, theoretically, we would have expected that the total rate of return of our Cornerstone style of management over the last 12 months would have been around 15.75%, not the near 19% that it actually returned. A 19% total return when we were expecting under a 16% return is good, right? Well, let's say it's not bad, but not something to get all excited about either, because the extra 3+% was not "earned"in our way of viewing things. You might say it just happened. The question, of course, is isn't that the way all money is made in the stock market, it just happens, doesn't it? Stock returns are random; that is what the dons of academe have been trying to tell us for about the last 40 years. We agree with the dons that in the case of many companies there does not appear to be a value driver, but in the case of consistent dividend payers its a different story. Our research shows that almost all consistent dividend payers have a unique and quantifiable relationship between dividend growth and price growth. Additionally, dividend growth and price growth intersect, or reach a kind of equilibrium about every 3 to 5 years. This means that our Cornerstone's outperformance over the last year can be explained in one of two ways: 1) It is a make up for an underperformance in the last three years, or 2) the portfolio's actual performance will lag a bit until more dividend hikes become apparent. Our best estimate for dividend growth for the portfolio over the next 12 months is just above 10%. With the portfolio's current dividend yield near 3%, that would mean that a good guess of what the Cornerstone portfolio might produce over the next 12 months is near 13%. This strong dividend growth implies double digit returns this year and next. Recently, rising interest rates have been a headwind to almost all dividend stocks, but history shows us that rising interest rates, unless they continue to rise on a secular basis, are not the main driver of very many stocks, even utilities and REITs. The main driver of most dividend stocks is the trend of their dividend growth. Thus, if the trend of dividend growth is sustainable, which we believe it is for many stocks, stock prices will soon stop their swoon and begin to climb again. Here's a real example of Dividend Talk. UTX, which I discussed a few blogs ago, recently announced a 21% dividend increase. The analysts were looking for a 14.5% hike. We think UTX's above trend dividend hike is a clear signal that it is likely to have a better year earnings-wise than Wall Street now is projecting. That means as the year progresses, UTX is likely to find new buyers with each successive positive earnings report. We are awaiting with great anticipation Wells Fargo's next dividend hike. We'll tell you why in a future edition.