Friday, August 19, 2011

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.