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."

Have Multinational, Dividend-Paying Companies Become the World's Safest Investment?

Investment Policy Committee Notes

Summary Points:

•  Debt ceiling saga continues to keep markets in flux
•  Debt Rating agencies forewarn of credit downgrades for the world’s few AAA rated countries
•  The European Union scrambles to reschedule Greek debt
• The Municipal bond market somewhat stagnant as investors await Congress’ decision on the debt ceiling
•  2^nd Quarter company earnings continue to outperform

Discussion

Needless to say, there is a barrage of perceived and real worries in the world today.  Most pressing in our view, however, is the topic of the United States debt ceiling, and the anticipated outcome of Congress’ decision to either raise the limit or let the U.S. default.  The Donaldson Capital Management Investment Policy Committee (“IPC”) discussed at great length what truly constitutes a default. We have read many publications, and watched several news conferences in order to learn of the possible outcomes.

Timothy Geithner, the U.S. Secretary of the Treasury, seemed to dance around an interview question on the plausibility of the U.S. defaulting on its obligations.  Although he did not confirm that the U.S. would default, he did say that by definition the U.S. could be in a ‘technical default’.   Essentially we understood this to mean that without the debt ceiling being raised, with the current level of Government outlays exceeding tax revenues, certain obligations would not be paid.

This is where it gets a bit fuzzy.  There will be a natural order to things, or rather, a priority of who will get paid first in the hierarchy, but how that order is defined is the real question.  While difficult to determine who would get paid and who wouldn’t, the Government realizes that its creditors are made up of countries and large institutions with a strong investing prowess. Therefore it is very important the U.S. make good on its debt obligations to these creditors because we will have to go back to them for future borrowing needs.

However, should the U.S. fix its deficit issues off the backs of those dependent upon their monthly paychecks such as retirees or the disabled by taking away or reducing these benefits?  Either way you look at this issue, it’s very difficult to determine the best way to solve the problem at hand. 

The markets have responded to the expanding uncertainties with mixed emotions.  They have become more volatile in the past few weeks but have traded in a reasonably narrow range.  What seems to be the issue with the uncertainty is uncertainty itself. 

Another correlating variable to the volatility of the markets is the debt rating agencies’ warnings of decreasing credit ratings for some of the strongest countries in the world.  Standard & Poor’s rating agency, along with Moody’s and Fitch’s have all stated they will remove the U.S's AAA rating should either no deal, or a perceived insignificant deal, be passed.  This trend has extended, however, to other countries such as Germany.  This is rather surprising considering the positive attention the Germans have received for their strong fiscal budget and spending discipline.

This may be an unprecedented time in history to have the world’s ‘riskless’ investment (i.e. U.S. Treasury bonds) take on the risk by being downgraded.  What, then, should the world use as a benchmark for risk premiums, capital cost configurations, and the like?  It is the belief of the IPC that no matter the outcome, the U.S. policymakers will do what they can to prevent default and perhaps safeguard the status quo.

Not only so, but as it pertains to investors, differing investment options are graded on a curve. When surveying the world and all the differing investment securities available (from stocks, to bonds, to cash, to foreign currencies or securities, etc) investors perform a mental accounting to rank various investment options against each another.  While there is the real possibility the U.S. debt rating could be downgraded, generally speaking the U.S. is still one of the safest places in the world to invest one’s money. 

A comparison to the bailout plan offered by the European Union to support Greece shows the situation in the U.S. could be much worse.  Private holders of Greek debt are taking a 21% haircut on their investments, which is causing grumbling among investors.  As we have seen, a rippling effect can occur across the European Union should one country default on its obligations.  We are optimistic, however, to see that a new Greek debt restructuring plan should whittle down the country's debt-to-GDP ratio closer to 100% (a more manageable level). 

The IPC then turned its attention to the municipal bond market and noted that the issuance of new bonds has slowed dramatically.  It would take several more paragraphs to explain why, but Congress’s decision to limit new Treasury bond issuance as we near the federal debt ceiling has had the effect of reducing the number of new municipal bonds coming to market.  Therefore, the municipal bond market has now been, at least temporarily, impacted, by the debt-limit standoff.

That is not good news, but there is some good news about credit quality in the municipal bond market.  A recent analysis of our bond holdings showed significantly more upgrades than downgrades.  In fact, the municipal bond market as a whole has fared very well this year, especially in retrospect to analyst Meredith Whitney's dire prediction.  If you remember, she proclaimed there would be hundreds of billions of dollars worth of defaults in 2011.  So far in 2011, only $750 million have defaulted; a far cry from her forecast.  This compares to the amount defaulted in 2010 and 2009 of $2.5 billion and $4 billion, respectively.

Lastly, the IPC discussed corporate earnings for the 2nd Quarter.  So far in this earnings reporting season, a little over 200 companies within the S&P 500 have reported.  Earnings have continued to outperform in both year-over-year growth,18%, as well as earnings surprises,7.5%. (defined as the difference between actual earnings and analysts’ estimated earnings.)  These big earnings gains have also resulted in sizable dividend hikes.  In our two main dividend investment styles, dividend increases over the last year have averaged nearly 14%, the highest growth rate in many years. 

In the spite of all the news that is causing volatility in the stock market, U.S. companies are still expanding and growing at an impressive rate.

Many questions remain regarding the final outcome of the debt-limit stalemate in Congress.  Because this stalemate involves the heretofore safest investment on earth, U.S. debt securities, the options for a perfectly safe hiding place are very few.  Furthermore, we remain convinced that this stalemate will be broken and when it is the few investments that are doing well right now like gold and Swiss,Canadian, and Australian currencies will fall in price.  In essence to invest in these securities at this time is to bet that the U.S. will not only default but remain in a defaulted condition for an undetermined time.

As we have said on many occasions, it is becoming clear that high-quality, multinational corporations may now be the safest investments in the world.  They have piles of cash, significant free cash flows, modest debt loads, compete in every corner of the world and charge a price for their services dictated by the market and not decree, pay taxes in every country in which they operate, and return a significant portion of their annual earnings to their shareholders in the form of dividends.  Go back through this list of attributes and you will find few similarities with most sovereign debt in the world.

We'll report again next week on how the fiasco in Washington DC is playing out.

Dividends Are Rocking and Rolling

Dividends have rocked and rolled over the past five and half years.  The question is where will they be dancing from here?

The chart at the right shows dividends paid by S&P 500 companies on a rolling 12 month basis since December of 2005.

For the first three years of this period, dividends rolled higher, peaking near $31.  Beginning in August of 2008, dividends fell like a rock, a move that more than wiped out the gains since 2005.  Since the early part of 2010, dividends have once again reversed course and are now rolling back toward their old highs.  Can this roll continue, or are there more rocks in our future?

Over the last 12 months, S&P 500 companies have paid roughly $25, still far below the nearly $31 all-time high they recorded at the peak in 2008.  However, the red dashes at the far right of the chart show Bloomberg's quantitative estimate of total dividends paid by year-end 2011.  Bloomberg believes that the current roll will continue.  They estimate total dividends for 2011 will reach $29, not far from the all-time high.  Bloomberg also estimates that the old high will be reached by the end of 2012.

If 2011 total S&P 500 dividends paid do reach the $29 estimate, it would mean that dividends would have grown for the year by nearly 21%.  Many analysts estimated that S&P 500 earnings would likely grow at that rate,  however, almost no analyst we follow made such a bold estimate for dividends.  After all, corporations have been fiercely focusing on free cash flows, and dividend payouts diminish cash.

We believe this dividend revival makes complete sense.  Corporations have produced tremendous free cash flows in recent years.  This build up in cash has three main potential uses: 1. share buy backs, 2. acquisitions, and 3. dividend hikes.  The companies we follow have done a little of all three, but they have hiked dividends at a higher rate of growth than we would have expected.  We believe the reason for this has been the growing recognition by many firms that dividend-paying stocks are enjoying renewed interest among many investors, particularly those near or in retirement. In hiking dividends they are just doing what their shareholders want.  I realize this is a very novel idea -- that a company would do what its shareholders want -- but we believe that is exactly what is happening.  There are some firms that have hiked their dividends two and three times in the last twelve months.  Activity of that kind is not an accident.  They know what they are doing and they have the cash flows to afford it.  We believe this dividend roll will continue.

If dividend hikes have been on a roll and stock prices follow dividends, a theory to which we subscribe, then current stock prices may roll a lot higher.  We would not be surprised to see them back to their old highs seen in 2008.  This won't happen in the next six months, but we can see it occurring by the end of 2012.

There are certainly all kinds of worries to contend with, but having a positive outlook is sometimes the best strategy when everyone seems to be throwing rocks at the market's prospects.

A Lot of Bullet Points That Add Up to Stocks Being Higher by Year-End

Summary Points:

• Continuing to assess stock market outlook – balance still positive
• Recent pullback in stock prices has been moderate on low volume

Discussion

The Donaldson Capital Management Investment Policy Committee continued our review of economic data and forecasts for the year. While the economic headwinds are much in the news, it is our experience that positive events get less play in the media than negative ones. To try to identify an appropriate balance, while recognizing that items listed are not all equal in impact, we built our own list of significant headwinds and tailwinds.

 Headwinds

• QE 2 ends this month.
• The May new jobs number came in way below trend.
• The European Economic Community has not yet solved the Greece problem.
• Consensus 2011 global GDP growth expectations have dropped 0.5% or so.
• National average house prices are still dropping.
• The unemployment and “functionally unemployed” rates have ticked higher.
• State and local governments are still eliminating jobs.
• Savings rates are high, potentially reducing consumer spending.
• Gas prices are ~$1/gal. higher than a year ago.
• Congress has not passed a solution to the Deficit and Debt problems.
• Regulatory uncertainty exists in regards to: health care, taxes, and banking.
• 3/11 Tsunami had bigger effect on supply chains than was previously thought.

Tailwinds

• Reported corporate profits remain strong.
• Estimates for 2011 corporate profits have held, despite economic headwinds.
• GDP growth outside the U.S. and Europe remains robust.
• Capital asset purchases (e.g. trucks, cars) are recovering significantly.
• Banks are seeing a slowing of defaults on mortgages and credit card debt.
• The weaker U. S. dollar is boosting U. S. exports.
• A debt default by the U.S. is seen as very unlikely by most economists we follow.
• Stock values (price/earnings) are now lower than the 80-year average. No bubble
• About 50% of S&P 500 sales come from faster growing, non-US economies.
• Crude oil and gasoline prices are dropping from recent highs.

The Committee also reviewed a discussion by The Bank Credit Analyst of the US economic outlook. BCA is a Canadian firm (which we believe gives them objectivity about the U.S.) that we’ve followed for many years. Their analyses are well reasoned; they do not rant or get emotional; and, they use data to develop and explain their views. A synopsis of their June 8 presentation follows:

• US growth will accelerate later this year.
• Tsunami-related supply chain problems are easing.
• The savings rate is high, but slowly dropping, benefiting consumer purchases later.
• Housing is too low to sink much further, reducing its drag on the economy.
• US structural deficits are only about 5% of GDP, more manageable than many think.
• The US tax/GDP ratio is the lowest in G-20, encouraging economic growth.
• The US has added more than 1.3 million net new jobs over the past year.

The Committee was concerned about the Fed’s recent lobbying for the 35 largest banks to raise their Tier 1 capital levels from 7% to 10%. This will continue to put pressure on bank stocks in the near term because of the potential dilutive effects of big equity underwritings. So far, this is still in the talking stage, and the banking industry is pushing back very hard. It remains to be seen how this will play out, but for the moment it has already been priced into the stocks, so any softening of the Fed’s position should provide a quick lift to the banks.

Although industrial stocks have dropped more than the S&P 500 lately, most industrial companies continue to have very bullish outlooks for 2011. CEO Sandy Cutler of Eaton Corp (ETN), for instance, is very confident his firm will see 14% revenue growth with earnings growth much higher than that. Many of Eaton’s customers delayed purchases of expensive capital goods during the recession, but these customers are now back in the market because the average age of their equipment has reached multiyear highs, causing repair costs to jump. This same dynamic is playing out across the spectrum of a number of industries.

Unemployment remains stubborn. Historically, however, the correlation between increased corporate profits and increased employment is very tight. The two trends separated during the recession. However, the average work week, especially in the industrial sector, has extended to the point where more overtime just may not be possible. The longer corporate sales volumes and profits grow, the more pressure there will be for businesses to increase hiring.

While major new negative developments in the Middle East, a major economic slowdown in China, or a fiasco on the debt limit in Washington D.C. could turn the 2011 outlook decidedly negative, we don’t consider any of them as having a high probability at this time. Our views are echoed by the economists and strategists that we follow. The market pullback over the past six weeks – the first six-consecutive week pullback in 10 years – has been relatively modest, less than 5%. Finally, trading volumes have been relatively light, potentially indicating there is not a lot of urgency in the selling.

After considering all the above, the Committee is holding to its outlook for stocks to return 5% - 10% for all of 2011. Of course, we will continue to monitor the data and the economic and political environments.

Edited by Randy Alsman

Greg Donaldson Mike Hull Rick Roop Randy Alsman

We own many industrial stocks including Eaton.