A Summer Stroll -- Part 1

Many of you reading this blog may already be dividend believers, and all I have to do is say dividend, and it has a fully formed meaning to you. I would be willing to guess that many of your fully formed good feelings about dividends are wrong. Others of you are absolutely clueless as to dividends having any value at all. You don't know that you are wrong, but you are. I think I know a lot about dividends, but I'm sure I'm off base in some areas, as well. I'd like to take a stroll this summer with any of you who want to come along and move beyond the concept of the dividend to the reality of what it means to invest, and what we mortals can expect. To do that I want to tell you a story. I will do it in small snippets, so I can be consistent and get us through this by the end of the summer. You may pass along this blogsite to anyone you like for our journey, and please do so. I find I understand what I know and believe, best, through other people's questions. I can't answer every question, but I'll try to give a general reply to areas of questions. This blogsite is an inhouse organ of a money management firm. It will be open only until the fall. After that we will close the door and only allow our clients and employees to view it. It is now open to the public to see how many people have an interest in dividends and are they digging deeply enough to find us. Within in the next few days, I will begin the walk. Get ready, I think you'll find it interesting.

Noise

Stocks fell by 420 points during a three-day rout last week. The question on a sunny Monday morning is: what's going on? But really isn't that the question that could be asked any day of any week, and 99% of the time the answer is -- nothing. It's just noise, or as academia says, randomness on display. There is no predictive power for the market's year ahead rate of return from the market's action last week and certainly none for the market's three year performance. Yet, the media will twist this around the neck of somebody or something until we are sick of it. If we want to deal with what is really going on we need look no farther than the dividend. Over the last 45 years, there has been a 92% correlation between the annual dividend of the DJIA and its price. If we add interest rates as a variable, there is almost a 95% correlation to price. Now, we are talking about something significant -- not noise or randomness. If we plug in today's dividend of $216, the historical correlation reveals the market should be trading at 11,099. If we add interest rates to the mix, the projection points to a 11,542. Either way, stocks are too cheap. The bottom line is with dividends for Dow Companies expected to rise 10% this year, and with our model saying the Dow is already 10%-15% under priced, the Dow, from a statistical perspective, now has less risk, not more as the pundits would have you believe.

Dividends on the Rise

Standard and Poors has just released their first quarter analysis of dividend actions by the 7000 companies in their universe. The number of companies increasing their dividends in the quarter grew by 16.9% over 2004 and 29.7% vs the same period in 2003. S&P believes the dividend increases will continue because of three forces: 1. very strong growth in cash flow, 2. dividends are now taxed like capital gains, and 3. the meandering stocks market. They make the point that the meandering stock market will likely prompt companies to show their shareholders the money in the form of dividends and rely less on share buy backs. S&P believes that dividends have returned to favor among investors much more than we do, but we agree with their assertion that in these wobbly stocks markets, cash dividends will catch the attention of more and more investors.

The Bank is Open to Those with an Open Mind.

I know all about the worries of our day--rising interest rates, inflation, falling dollar, balance of trade, deficits, and a stock market that can't seem to find its legs. But in the midst of the wall of worry, I think there is a simpler, better, and more meaningful message that investors should hear. Dividends are on the rise and dividends matter. I spend a lot of time making educated guesses about the future. For a change, I thought I would take a 20/20 look back. For the sake of discussion let's say ten years ago Wells Fargo, traded at $14 and paid a $.45 dividend, for a 3.2% dividend yield. Let's think the worst and assume that the wall of worry that was present in 1995 (the wall is always with us) was correct and WFC's stock price did not move a penny over the next 10 years. During this time, however, its dividend grew to $1.87, a 15.3% compounded annual rate. While the dividend growth is impressive, the rate of return for the period will still have to take into consideration that the price of the stock did not increase at all. In this hypothetical case, the annual internal rate of return for the period would have been 7.05%. That is acceptable, but not up to the 10%+ historic returns of the major stock averages. But consider for a moment the odds of WFC actually increasing their dividend over 15% per annum for a decade and the price NOT going up. It is impossible, because if it did it would be yielding over 13% on the original investment ($14/$1.87). Rising Dividend Investing is such a powerful idea because, dividends are vastly more predictable than stock prices. Yet, a consistently rising dividend will ultimately do what worry, wishes, and pipedreams can not--it will produce solid total rates of return and permit you to turn off CNBC and have a good night's sleep. Too many people are thrashing about in the dangerous waters of trading the news, when they could be sitting on a bank, literally.

Shiny Fish---Not

Dividends have regained some stature over the past few years, first because dividend-paying stocks held up better during the recent bear market, and subsequently as President Bush championed a tax cut on dividend income. Additionally, with a series of corporate scandals souring investor confidence, many companies have tried to woo back investors with generous dividend hikes. Judging from the zillions of words splashed through the media regarding investing and individual companies; however, we don't think dividend investing is anywhere close to becoming a way of life. At best, it is a curiosity, and that is fine with us. As long as investors play the trading game, we are almost assured of being able to find bargains among dividend-paying companies. A perfect example of this is the definition of the word dividend itself. If you look up the word in the Microsoft dictionary(http://encarta.msn.com/dictionary_/dividend.html) you will find the first definition is bonus. That is decidedly not the first meaning in any long-established dictionary. In most dictionaries, the root of the word is described as dividere, to cut. In essence, the modern meaning of the word is unexpected bonus, ie., the peace dividend, while the ancient meaning of the word is "my cut" of the profits. In short a lot of people are walking around thinking that dividends are a bonus, while we see them with the steely-eyed focus of an accountant. The dividend is our cut--what we are due--not a shiny fish that jumped in our boat. As long as Microsoft and other modern dictionaries continue to list bonus as the first meaning of the word dividend, we are safe in our reliance on using our "cut" to value and appraise companies we own and are considering.

Sweet Idea

We have recently begun to nibble on Nestle-NSRGY, $69.59 (ADR), the Swiss food giant. Nestle is under the radar for most US investors because it is not followed by many US research firms(only two), and it's daily trading volume is relatively low. Having said this, it is a powerhouse of a company. Nestle does approximately equal business in the US, Europe, and the Far East. It is a leader in Ice Cream (Dryers and Hagen-Dazs), Candy (Lifesavers, Nestle, and Kit Kat), Pet Food (Purina and Alpo), bottled water (Perrier, San Pellegrino, Arrowhead, Calistoga), and Coffee (Taster's Choice and Nescafe). It also has holding in Alcon and L'Oreal. Nestle earns our Dividend Star status by having increased its dividend for at least the last 10 years in a row. It has a current dividend yield of just over 2%, and the dividend has grown by over 17% per year over the past 5 years. It is trading at 17X 2005 earnings, and they recently announced they will initiate a program to retire shares. Finally, it is one of the few companies in the world to earn the AAA rating for financial strength. Of particular note, our research shows it is negatively correlated to rising interest rates. That means, historically, its price has risen in periods of rising interest rates. Sweet, very sweet.

We Can Hear You Now!

We have held Verizon, the telecom co., for the past few years with little to show for it. We have done so because we believed that it was emerging as the dominant phone company in the US. It's been a tough hold because, during this time, VZ has not increased its dividend. Let's see dying industry, no dividend hikes--this sounds like the anti-Rising Dividend stock, not the real thing. We have held VZ for three reasons: 1. Telecommunication is an essential service, which is a hallmark of Rising Dividend Investing, 2. They have had massive free cash flow all along, so we knew they could have been increasing the dividend if they had wanted to. 3. Point 2 usually does not carry much weight with us, but in the case of VZ, they were using the cash flow to pay down debt, which we think is a good proxy for a dividend hike. This past week, VZ announced a 5.2% increase, their first such increase since 1997. With their debt now almost half what it was just a few years ago, we believe more dividend hikes are coming. With its current dividend yield of 4.4% and the 5.2% hike, it will post a dividend return for the coming year of 9.6%. We wouldn't be surprised if the total return for the stock did the same.