Newsletter - Q4, 2010

May 11, 2010

Revisiting the Importance of Dividends & Company Valuations

By James C. King

Two elements of the investment process that we strongly focus on are dividends and historic valuations (P/E ratio).


Underestimated by many investors, dividends contribute significantly to the overall total rate of return.  Over the last 20 years, dividends have contributed over 40% of the entire +453% total return of the S&P 500’s stock index.  (See Chart 1)

Source:  Bloomberg.  20 years historical price change 11/30/90 - 11/30/10

While the dividend rate is important, it is even more important to analyze earnings coverage of the dividend and the consistency of dividend increases.  Most companies with ‘higher’ dividend yields do not increase their dividends consistently.  Yet, lower yielding companies that raise their dividends annually will result in more dividend income over longer periods of time.  Companies like Johnson & Johnson, Procter & Gamble and McDonald’s have increased their dividends annually for at least 25 years.  Overall, U.S. companies are currently paying out, in the form of dividends, just 28.6% of their profit, well below their 50-year average of 47%.  As an added plus, dividend income is currently taxed at a maximum federal rate of 15% as opposed to 35% on corporate bond income.  To highlight a final benefit, my partner Dennis Ott’s article shares examples of how many high quality large cap stock’s dividend yields are at equal or higher rates vs. their 10 year bonds.

Historic Valuation (P/E ratio)

As an important element of the investment process, we consider how a company’s stock price relates to the company’s earnings on a historical basis.  This analysis must be taken within the context of the overall stock market.  The current price/earnings ratio of the S&P 500 index is 13.85 which we consider to be in the lower quadrant of the indexes historical range. (See Chart 2)

*Quarterly data based on 12 mo. reported earnings from 1936 - 09/30/88 & 12 mo. operating earnings from 12/30/88 to present. Source:  Standard & Poor's

The same analysis applies to individual companies.  As an example, Johnson & Johnson is currently selling at 12.64x its lagging 12 month earnings.  Historically, the company has sold for as high as 30x earnings.  Their earnings growth, as with many other companies have slowed in the last several years, however this has been more than adequately discounted in the stock price.

I hope this discussion is somewhat useful to your understanding of stock dividends and valuations.  I am starting to bore myself, however, so I will end this here.  Happy Holidays!

Cash, Cash, Cash—What To Do With The Cash?

By Steven E. Landberg, CFA

Over the past several quarters, companies’ balance sheets have reflected an increasing amount of cash and short-term investments.  Since the recession officially started in December of 2007, corporations in the S&P industrial index (excludes financials, transportation, and utilities) have increased their cash holdings by 38% to an unprecedented level of $842 billion.

These increases are derived from deep cost cutting in response to the recession’s economic uncertainties and the resulting elevated free cash flow realized as companies are beginning to grow out of the recession.  Additionally, there has been an increasing amount of debt issuance at the current favorable financing rates.

Now, the question becomes, “What to do with all of the cash?”  We see corporations using their high cash positions for increasing dividend payments, mergers and acquisitions (M&A), paying down debt, buying back shares, reinvesting in operations, and simply retaining and allowing cash levels to grow.

Several companies have increased the amount of dividends paid to shareholders. A local example is Target, which recently increased their quarterly dividend to 25 cents a share, a 47% increase.  We anticipate quite a few more companies will follow suit.

Also in our backyard, 3M has been actively using their cash for mergers and acquisitions. At its recent 2011 outlook meeting, 3M announced it is allocating another $2 to $3 billion towards M&A. This compares to the $2 billion plus spent during 2010 (highest in a decade) and the paltry $69 million spent on acquisitions during 2009.

With rates at historical lows, many corporations are and should consider issuing debt to raise additional capital.  IBM just issued $1 billion in 5-year notes yielding just over 2%.  Earlier this year, IBM issued $1.5 billion in 3-year notes at 1%.  Some would say, “Be careful though, as this is simply matching cash with future obligations.”  However, an increase in cash by means of inexpensive financing may prove to be quite beneficial for the long term growth of companies.

To date, we have seen some increased spending to upgrade technology.  As the recovery cycle continues, companies will increase capital expenditures and reinvest capital into operations. At a later phase of the recovery, and as economic and political uncertainties subside; companies will use their cash to hire additional employees.  Stay tuned.

There is a viewpoint which states, “Individuals save and corporations invest”.  As cash continues to build on corporate balance sheets, investors are beginning to demand corporations put elevated cash levels to work. As a result of this outside pressure, we are seeing more corporations and their boards pushed to take action.

Individuals have been saving and corporations have been saving.  As corporations ponder the most appropriate use of cash, we believe that now is the time for them to take action.  We view that they should either invest the excess cash built up on their balance sheets, or return the cash to shareholders through share buybacks, and/or increasing dividends paid.

Beware of the Bond Bubble

By Dennis M. Ott, CFA

My Partner, Jim King, recently said that the market generally moves in the direction that embarrasses the greatest number of people.  Over the past year or so, an increased number of investors have sought the “safety” of bonds.  They have done so with such gusto that we fear this perceived “safety” of owning bonds will turn to disappointment as interest rates increase.

The potential decrease in value of even owning the highest quality of bonds will be quite large with only a slight increase to rates.  If prevailing rates increase just 1% over the next six months, a Government bond maturing in 5 years will decline nearly 5%; a bond due in 10 years will decline nearly 8% and a 30 year bond will be down nearly 15% over the same six month period.

With this increasing flight to safety, investors have also bid up the price of corporate debt causing yields to drop to levels where high quality equity dividend yields are equal to or higher than their company’s debt.  Some examples of this are: Johnson & Johnson stock yields 3.4% - their 10 year debt at 3%; Proctor and Gamble, 3.1% - their 10 year debt at 3.3%; Verizon, 6% - their 10 year debt at 5.5%,  AT&T, 6% - their 10 year debt at 5.5%, and McDonalds, 3.1% versus 3.2% for their 10 year notes.

With corporate bond debt being overbought and the potential for interest rates rising, which yield would you rather own - a 10 year corporate note or a high quality stock, at a lower valuation with solid growth potential over that same ten year period? It is interesting to note too that all of these above mentioned companies have long term records of increasing dividends.

It would seem that investor’s may be paying too much for “safety.”