In Keeping Your Dividend Edge: Strategies for Growing and Protecting Your Dividends, Todd Wenning, CFA, an equity analyst, investor, and writer based in Cincinnati, describes the new market environment that necessitates a revised approach for selecting and monitoring dividend-paying stocks. He succinctly describes three major changes that have altered the dividend landscape over the past decade.
The first major change is that more US and, increasingly, non-US companies have elected to implement stock buybacks as an alternative to dividends for returning cash to shareholders. From the dividend investor’s perspective, stock buybacks should be used only if the stock is undervalued and there are no superior internal investment options. However, most companies lack buyback discipline and destroy shareholder value, because buybacks tend to increase when the market is high and decrease when the market is low. Wenning provides a chart that documents the positive correlation between the level of the S&P 500 Index and total gross buybacks.
The second major change is that the 2008–2009 financial crisis brought about the most dividend cuts since the Great Depression, which has altered both corporate and investor expectations. Some of the cuts came from companies that had not cut their dividends in generations. Consequently, investors must recognize that companies that have always increased their dividends in the past may actually cut their dividends in the future. The author recommends a holistic approach to dividend analysis, including analysis of, among other things, earnings cover, free cash flow cover, operating margin, return on equity, dividend track record, and company annual reports.
Finally, the third change is the increasingly competitive business environment. The average lifespan of an S&P 500 company fell from 61 years in 1958 to only 18 years in 2011. Large, dividend-paying companies today need to stay innovative, or they might find themselves becoming the next Kodak or Nokia. According to a recent Harvard Business Review article cited by Wenning, public companies have a 33% probability of being delisted in the next five years, which is six times the delisting rate of companies 40 years ago. It is more important than ever to consider a company’s competitive position prior to making a long-term investment because a company with deteriorating competitive advantages may be under pressure to cut its dividend.
The author briefly summarizes arguments against dividend-focused strategies. Efficient market hypothesis adherents claim that dividend strategies are irrational and an anomaly. Behavioral economists argue that dividend strategies are manifestations of investor biases, such as loss aversion and regret avoidance. I concur, however, with Wenning, who states that the presence of a dividend relieves investors of the need to make frequent buy or sell decisions, which often turn out to be mistakes, while providing fresh cash to invest in new opportunities.
Wenning argues that in executing a dividend-based strategy, investors should avoid ultra-high (over 4%) and ultra-low (below 2%) dividend yields and target a dividend yield “sweet spot” of one to two times the market average. Any rate lower than 2% is not likely to produce sufficient income over the next five to 10 years; anything above 4% is pushing into higher-risk territory. As of early February 2018, the S&P 500 dividend yield stood at 1.87%, putting the dividend yield “sweet spot” at 1.87% to 3.74%.
I would be interested in the author’s view on whether investors should remain patient with a large-cap, blue chip stock that stays depressed for an extended period. As an example, General Electric currently pays a 3.2% annual dividend yield and is trading at about 75% below its 2000 high, 60% below its 2007 high, and 56% below its 2016 high. The reward for patience in this case was that in November 2017, GE cut its dividend for only the second time since the Great Depression.
In summary, the author emphasizes that sound dividend investing is about buying well-run businesses with good yields and strong competitive positions at good prices while also being diligent and patient. Ultimately, investors should pursue the strategy that they find most intellectually and emotionally satisfying. Otherwise, they will not stick to the strategy. Although some investors prefer such other strategies as growth investing and mutual fund investing, I believe that the author is correct in concluding that dividend investing has characteristics that support an individual investor’s competitive advantage — namely, the ability to be patient and think long term.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.