Dividend Myths Uncovered and Discussed, Part I

The single biggest misconception about dividend investing is that rising or falling stock prices are directly linked to the dividend paid by a company.  Investors, particularly those in retirement, are often pleasantly surprised to learn that even though stock prices might be falling their incomes from stock holdings are unchanged or even rising.

Such is the case today.  Stock prices have fallen sharply over the last two months, but in those same two months dividend income for both the S&P 500 and the Dow Jones 30 has risen.

Clearing up the confusion is easy.  Dividends are declared and paid by a company on a per share basis, not on a yield basis.  For example, let's look at McDonalds (MCD).  MCD currently pays a dividend per share of $2.44.  At today's price of  $85.61 per share, that $2.44 dividend equates to a current yield (dividend/price) of 2.8%.  Whether the stock goes up down or sideways, the dividend will stay at $2.44 per share until the company changes it.  In this case MCD has raised their dividend for the last 38 consecutive years.

This brings us to the second most common mistake that investors make about dividend investing, i.e., the current dividend yield as stated on the internet or in the paper is not necessarily your dividend yield at cost.  This is a somewhat more difficult concept to understand, but the math is still simple.  Let's say you bought MCD in 2007 when the price was near $49 per share.  To calculate your yield at cost, you divide the current dividend of $2.44 by your purchase price of $49.  Your yield at cost is nearly 5%.  When people learn of the concept of yield at cost, their first reaction is, "Am I really making 5% on my money today?"  The answer is yes.  Indeed, you are making a lot more that 5% per annum on MCD because its price has nearly double over the last four years.

Yield at cost is one of the most overlooked concepts in all of investing.  It is also why a lower yielding stock with a high dividend growth rate may actually produce a higher long-term cash flow than a high yielding stock with low dividend growth.  This is all courtesy of the power of compounding.  A dividend growing at 3% doubles in about 24 years; a dividend growing at 7% doubles in about 10 years; and a dividend growing at 15% doubles in just less than 5 years.  In this way, a stock yielding 2% today with its dividend growing at 15% per year will yield nearly 8% in 10 years.  We cannot overemphasize the power of growing dividends too much.

Most people know that dividends, unlike bond interest, are not guaranteed.  Dividends are paid solely at the discretion of the board of directors of the company.  Many people worry that falling stock prices are just a precursor to dividends being cut.  We always remind people of our experience in 2009.  Of the 30 stocks that we held in our Cornerstone portfolio at year end, 20 had raised their dividends, five had held their dividends steady, and five had cut their dividends.  That was the most companies we have ever had cut their dividends in a single year.

Our world is the world of rising dividends.  Companies that can raise their dividends almost every year are very rare birds.  Next time we will talk about some of the qualities we look for in selecting stocks for our portfolios.

We own McDonalds in our portfolios.

Are Dividend-Paying Stocks Becoming Better Than Bonds?

Speculators are throwing stocks around like dead fish, but even a simple analysis of companies in the S&P 500 shows that they are very much alive.  There are now 214 companies in the S&P 500 that have a dividend yield higher than the 2.10% yield of a 10-year US Treasury bond. 

These 214 companies have an average current dividend yield of 3.70%.  Importantly, as an indicator of their vitality, these companies have increased their dividends by an average of 8.20% over the last 12 months. This level of dividend hikes is eye-popping when considering that the US economy grew at only 1.60% during this time.

For the S&P 500 as a whole, the current dividend yield is 2.25%, also higher than the 10-year Treasury bond.  But when including the additional 286 companies whose yield is lower than the 10-year Treasury bond yield, or pay no dividend at all, the average 12-month dividend growth has been just over 14.0%.  During the same time, earnings for the S&P 500 grew by close to 12%.  That means that companies actually grew their dividends modestly faster than their earnings were growing.  Would dead fish companies do that?  Absolutely not.  A company would only hike its dividend at a faster rate than its earnings if it was completely confident that it would not need the money later.

So we have another one of those conundrums here.  The average company in the US is reasonably optimistic about its future.  We would add that the Wall Street analysts agree.  Last Friday, the analysts raised 2012 earnings to new all-time highs.  Thus, at the very time when the speculators were beginning to sling dead fish like there was no tomorrow, the analysts were pushing up 2011 and 2012 earnings. The actions of the analysts are vitally important in solving the conundrum:  It was almost exactly a year ago when the analysts also went against  the fish tossers by continuing to hike earnings for 2010 and 2011 even though stocks were selling off.  We all know now that they were right.  Earnings and dividend increases kept on rolling in and stock prices exploded.

We are not completely discounting the action of the fish tossers.  There certainly is a foul smelling odor coming from Washington these days, and the puny growth of the US economy stinks; but we believe speculators are missing the bigger picture.  World-wide economic growth is projected to be near 3.5% for 2011.  That rather spritely figure includes the smelly slow grow rates in the US and Europe.  The truth is the developing world is still showing solid growth, and, of equal importance, the developing world is a lot bigger than most investors understand.

In previous blogs we have extolled the concept of bond-like stocks.  Our view is for many companies the current dividend payments are very safe; indeed, we believe they will grow at solid rates over the next few years.  Mathematically, a stock yielding 3.7%, with its dividend growing at 7%-8% should clobber the current 2.10% return on a 10-year US Treasury bond.  It is not a guarantee, . . . but perhaps in light of recent events, we might say that questions have been raised about the credit quality of US Treasury bonds, as well.

Johnson and Johnson: A Regal Dividend Stock That Is Very Cheap

To dividend investors big sell offs like the one we have witnessed over the last couple of weeks provide tremendous buying opportunities. That may sound like a big DUH, but as Warren Buffett says, "When the water goes out it's easy to see who was swimming naked." We believe Mr. Buffett meant that statement in the context of wrong bets related to debt.  We have found, however, that "when the water goes out" in the stock market, it is much easier to see those companies that are not only fully clothed but are regally attired.  Regally attired in the sense of having the rare qualities of unquestioned safety and consistent growth.

There are a handful of companies in the world that can qualify under our most stringent safety and growth standards, unfortunately, these companies are almost always fully priced.  Everyone knows they are outstanding companies and everyone owns them.  The only time we can buy these regal companies at bargain prices is when a big sell off in the market causes people to abandon stocks in general.  When that happens, like over the last few days, the regal stocks get thrown out with the common folk.

Let us discuss one stock that we consider regal, Johnson and Johnson (JNJ).  Here is a brief thought process of why we rate it so highly and why it is the kind of stock we buy every time the "water goes out."

1. Safety:  JNJ is one of only four companies in the US that is still rated AAA.  Yes you heard that right.  S&P, in cutting the rating of US debt, went to great lengths to explain that JNJ's rating was not dependent on that of the US.  JNJ is AAA on its own merits of financial strength, diversification of business lines, geographic diversification, growth, and sound leadership. JNJ has more cash than debt. 
2. Growth:  JNJ has grown its earnings by an average annual rate of 7.5% over the last 10 years.  It dividend has grown in the low double-digits%.  With the uncertainties of the new health-care plan, we project that JNJ's dividend growth rate will slow to the 7.5%-8% level over the next 3-5 years. At that rate, JNJ's dividend will double in about 10 years.
3. Dividends:  JNJ's current dividend yield is 3.7%.  That is nearly 1.3% more than the yield on a 10-year US Treasury bond.  The company has paid a dividend since 1944 and has raised it dividend every year for the last 48 years.
4. Valuation: Our proprietary Dividend Valuation Model is estimating that JNJ is just over 30% undervalued. 
5. Timing: We don't try to time the market, but the manner in which stocks have fallen in recent days usually takes time to calm down.  We think JNJ is a good value at current prices, but with a bit of patience one might be able to buy it a bit cheaper over the next few weeks.

We own JNJ and plan to buy more.

A Prayer For Our Leaders And Our Country

A dear friend of mine called today and was mad as a hornet about the recent sell off in stocks.  He quickly stated that he knew that stocks go up and down and that volatility was always present in the stock market.  He was not angry so much about his big paper losses because he was living off the income of his portfolio, and he agreed with me that the income was secure.  He said his anger was directed toward the United States Congress and the President because they had all brought on the carnage in the stock market by their recent show of ineptitude in passing the debt-ceiling increase.  He said, "They have made us the laughingstock of the world and given us the feeling that they are so rabid on both sides that only a crises can provoke them to agree on anything."  

He explained that only 50% of American pay Federal income taxes and yet the Democrats want to raise taxes on only those who already pay taxes, not on the hundreds of millions of people who pay no taxes. He uttered, "Everyday this feels more like we live in a socialist country."  

He was equally upset, however, at the Republican leadership because they could not reign in the wild bunch who were ready to shut down the government rather than raise taxes.  He said, "Where are the statesman?  Where is the reason?  Who is willing to serve their country rather than their ideology?"  He said a lot more that I cannot print.

I told him that I believed there were many other factors that had contributed to the recent weakness in stocks, the credit problems in Europe being number one.  "He said Europe is a zombie headed for 20 years of tepid growth just like Japan, but they despise the US so much that they would rather go bankrupt as a united entity rather than save their necks by abandoning their common currency."

I started to answer his latest mortar blast when I realized my answers were not the solution.  I said,"Sounds like we need to pray."

He almost shouted at me that that was the only thing that could save a corrupt and dimwitted world.  And so I asked him,"Do you want to start the prayer or should I?"

He said he was too wound up to pray and that my prayer would be much appreciated.

"Oh creator God;  Alpha and Omega, look down upon us your stiff-necked and self-serving people.  Grant us a measure of your wisdom; teach us your ways; and save us from our self serving ways.  Break our hearts, Lord, and help us to understand that even your Word says there will always be the poor among us whom you called blessed.  Those whose wounds You ask use to minister to.  Wounds You invite us to enter into that we may find our own healing, our own better selves.  

Teach us Lord when enough is enough.  Give us the joy of living in your Spirit, and the assurance that in You we have everything we need.  Indeed, more than we than we can imagine. Rest your heart and hand on the leadership of our country, Lord.  Humble the deceivers and the proud.  Enliven your Holy Spirit on this country we love and help us both to know the path we must follow--and to follow it.  But not just the US, Lord, but also the world You so love.  

Finally, God we ask that you walk with us as we pass through this dark season, that we might be comforted and guided by your light.  Amen. 

Do you have anything to add?"

"Do you really believe I can count on my income?"

"Yes, I do.  You have only high quality dividend paying stocks and investment grade bonds.  Your portfolio was built to handle this kind of weather.  The weather might be rough, but I believe the portfolio can handle it."  

"Amen.  Tell me the truth; you're just as mad as I am aren't you?"

"Yes,  I am, but you used up all the good lines.  That left me with only a prayer."