Thursday, October 16, 2014

Upcoming Dividend Hikes May Reveal What Corporate America Really Thinks

Europe’s economy is in a funk and may be heading for recession.  Terrorists in the Middle East have burst onto the scene straight out of some B movie horror show.  The Ebola crisis threatens to reap vengeance near and far.  In the midst of these threats and the unfathomable questions they pose, smart-guy politicians in the U.S. and Europe seem to have a strong resemblance to the Wizard of Oz after the curtain was pulled away.   

As an investor, where do we look for a glimpse of how these questions and issues will be resolved?  I have been in the investment business for nearly 40 years, and I have endured at least a dozen of these episodes when the vultures hanging in the sky were so numerous they left me stumbling around in the dark trying to find a light -- any light.  Indeed, the Rising Dividend Strategy that we use today was born during the crash of 1987, when the stock market fell by nearly 23% in a single day.  I went into that day believing that the daily stock price movements were the best indicator of where the stock was going in the near term.  I ended that day exhausted and humbled, but with a strange sense of hope.  Black Monday was such an egregious assault on my sense of how the markets worked that I realized such a selloff could not be driven by the fundamental soundness of the economy or of corporate America.  When all stocks go down, it is a signal that emotions have replaced reason in the driver’s seat because the prospects for all companies do not rise or fall in unison on a single day, week, or month.  

Our Investment Policy Committee has been studying and discussing the current sell off for several weeks.  What does it mean?  Is it for real?  How far will it go?  How will it end?  This past Monday we realized these were not questions that could be answered until after the selloff has ended.  We turned our attention to variables that our research has proved over the years to be the best predictors of stocks prices:  earnings, dividends, inflation, and interest rates.  We came away from that exercise very hopeful.  If the U.S. economy is headed for recession like Europe, corporate earnings should be soft.  The are not.  In fact, so far in this earnings reporting season they look better than last quarter. Inflation is anchored near 1.5%, and the ten-year Treasury bond yield has fallen to a multi-year low at near 2 percent.  Dividends are the real stars of the show.  They have already risen by over 10 percent for the year with nearly three months to go.  

None of these important variables of the U.S. economy and corporate America is signaling imminent bad news.  In fact, all of the data are headed in the right direction.  We concluded the current selloff must be looking over the hill at the aforementioned vultures and projecting that one or more of them will come home to roost, and the current good news will turn bad.    

After the crash of 1987, we gradually became dividend investors because we found that dividends were the best predictors of the true trend of stock market performance.  Dividends tell four powerful stories about the future trend of the stock market.:

  1. Dividends are cash money.  They represent a real transfer of wealth from a corporation to the shareholder, unlike earnings which can be engineered and may be here today and gone tomorrow.

  1. Dividends have represented over 40% of total stock returns over the last 80 years. Thus, not only are they real money, but they are also really important to total return for shareholders.

  1. Dividend cuts by corporations in the U.S. are almost always punished by the market. Corporate executives know this. Because of this, S&P 500 dividends have fallen, on an annual basis, only about half as often as have earnings. In addition, the annual volatility of dividends is only about one-third that of earnings.    

  1. The S&P 500’s long-term dividend growth of 5.5% is very close to long-term stock market price growth of 5.9%.  Dividend growth and stock market growth are not identical twins that move in lockstep, but they do shadow each other closely.    

In looking again at this list, we realized we had a tool that could give us a glimpse of what was going on in the economy over the hill beyond our sight.  That tool was the daily dividend announcements of corporate America.  In the long-run, the growth of stocks prices will look a lot like dividend growth.  Since corporate America is world renowned for its ability to rightsize costs with revenues, if top management sees trouble coming they will not only cut costs, but they will also cut back on dividend hikes.  We have many resources, including Bloomberg Professional Markets, that make dividend estimates.  By watching dividend actions versus Bloomberg’s estimates for all stocks, we should be able to see if companies are downshifting their internal growth estimates.

Why are dividend actions so important to our way of thinking?  American CEO’s live and die by their cash flow projections.  They do not want to spend an extra dollar on a project that is going nowhere or losing money.  Thus, they recommend dividend hikes to their boards of directors that reflect the company’s free cash flows that are not needed somewhere else. 

At present, Bloomberg and Wall Street analysts are predicting that dividends will grow at about 9 percent in 2015.  If that comes to pass, the recent selloff is a mistake and a great buying opportunity just like all the big sell offs in history have been.  If dividends remain flat or fall over the remainder of the year, then there may be more trouble coming than we are now projecting. Dividends only have to reach 5.5 percent growth to be in the normal range.  

So far in our study of dividend hikes the news is good.  Over the past month, dividends have grown 1.8 percent more on average than they were projected.  We will report our findings regarding dividend hikes on a regular basis throughout the end of the year.