The Curious Investor

When markets begin to turn or have already fallen, many investors turn to fixed income to weather the storm. Typically speaking, fixed income refers to bonds which pay a fixed amount each year to their holders. Hence, fixed income each year. For those who want to continue to have exposure to the markets, a portfolio of dividend paying stocks can often mimic such a portfolio and provide stability in tumultuous market conditions. First and foremost, dividend paying stocks allow you to hold a good company through a period of stock depreciation while still collecting a return for your investment. This gives you a longer time period to work with as far as waiting for price appreciation. Second, because of this less risky nature, investors, if they choose to stay in the market, will often overweight dividend paying stocks as the market tide turns. This benefits those who get in and go defensive early.

Dividends aren’t the be all and end all of investing, though. Their strength in weak markets also means they show comparative weakness in good markets. This is because good markets favor growth and potential over stability. A company which elects to pay dividends typically does so because it is in a mature market and realizes that it is making money in excess of what it can invest while still reaping a healthy return. Smart (or shareholder friendly) management will often elect to either give money back to investors in the form of a dividend or through share buybacks in order to boost the value of their stocks. A company with great growth prospects, on the other hand, would rather take all its generated cash and plow it back into the business. This phenomenon is best illustrated by the fact that in 2002, the last year of the tech bubble bursting dividend payers in the S&P lost 10.9% versus 30.3% in non payers. In 2003, when the markets began rebounding, non-payers gained 61.7% while payers only gained 33.5%. For those of you who don’t believe in market timing, believe in the power of stability in returns and compound interest. Over those two years, payers would have gained 18.5% and non-payers would have gained 12.7% (without factoring in the reinvested dividends). Those that don’t think that they could switch their portfolios on the fly to capitalize on payers versus non-payers are likely better served by investing in less risky, fixed income generating dividend payers over the long term.

So, how do you figure out if a dividend payer is right for you? Well, first and foremost, make sure that the yield is appropriate enough for your investing needs. Yield is basically the “interest rate” of a dividend paying stock based on the dividends the company either has indicated it will pay or the dividends it has paid. The key statistics sheet for a stock on Yahoo!Finance includes a section on both trailing twelve months and forward yields. While it may be attractive to go after the highest dividends you can find, don’t buy into unusually high dividends without requisite research. A terrific example would be American Home Mortgages which offered a dividend in excess of 11% just a few months ago. While management claimed it would be able to continue to pay, cracks under the surface resulted in the company not only lowering but canceling its dividend when the time came. This later signaled even larger liquidity issues and AHM declared bankruptcy. While this is an extreme case, this does underly how healthy, stable (or growing) dividends are often a bell weather for a company while decreasing dividends are usually a sign to get out. This also means that dividend paying stocks carry the extra event risk of not being able to pay dividends which often results in heavy sell-offs.

So, how do you protect against this? First, don’t get fooled by huge dividends. Don’t cross such a company off your list, but realize that you have to ensure that it will have the means to pay. Make sure the company has good free cash flow (operating cash flow minus capex). Also, don’t completely ignore growth. Make sure the company is growing at least at a modest pace as this is key to the company continuing to generate cash flows for your dividends. Also, take a look at the company’s payout ratio (dividend per share divided by earnings per share) if you’re really fancy do this payout ratio on free cash flow per share. This will give you an idea of just how much the company is returning to investors. A low payout ratio with a good yield is typically a good sign as it shows the company doesn’t commit to dividends yet still manages to return a material amount to investors and also shows there is room for the company to increase dividends. A high payout ratio means that dividend stability depends on the company’s continued stability or growth which is not overly enticing in down markets. Finally, look for value. If the stock is trading at a value and this is what is giving you a high dividend, you have found gold. Value implies healthy companies trading at below market multiples. Again, don’t fall into the value trap of buying a falling stock with depreciating fundamentals.

Bookmark to: