21 July 2007 – The Aleph Blog

Dissent on Dividends

Posted on 21 July 200722 July 2007 by David Merkel

Everything old is new again.? If we jumped into the “wayback machine” (?Where are we going Mr. Peabody??) and turned the dial to 1957 (?1957. We are going to meet Elvis, Sherman.?) we would find that the few equity investors that are there are highly concerned about yield, and that the yield on stocks was threatening to dip below the yield on bonds.

This was the twilight for yield-based investing.? Through the next fifty years, there would be among value investors a few absolute yield investors that prospered for a time, then died when interest rates rose, and a few relative yield investors who would die when credit spreads blew out. (Note: an absolute yield manager will only buy stocks with more than a given yield, like 4%; a relative yield manager will only buy stocks that yield more than a benchmark, like the yield on the S&P 500.)

As an example, when I was with Provident Mutual in the mid-1990s, I created a series of multiple manager funds.? One was a value fund that we were creating to replace an absolute yield manager who had done exceptionally well over the past 19 years, but cruddy over the last four.? Assets had really built up in that fund, and our clients were getting jumpy.

A large part of the problem was that interest rates had fallen from 1980 through 1993, but had risen since.? Buying steady cash generating low-growth companies while interest rates were falling was a thing of genius.? As interest rates fell, the dividend stream was worth more and more.? When interest rates rose, that pattern reversed, and 1994 was particularly ugly.? We sacked the absolute yield manager as a one trick pony.? A wise move in hindsight.

Now we have enhanced indexers basing whole strategies off of yield, because their backtests show that yield is an effective variable for allocating portfolio weights.? Given that the last 25 years or so have had falling interest rates, this should be no surprise.? Yield will always be an effective variable when rates fall; but what if rates rise?

Also, what happens when Congress does not renew the reduction of the tax on dividends?? Don?t get me wrong, I like dividends; my portfolios yield much more than the markets.? But I don?t go looking for dividends.? I look for companies that generate cash earnings.? What they do with the cash earnings is important; I don?t want management reinvesting the cash foolishly, but if they have good investment prospects, then please don?t send me dividends.

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.? That is true.? We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.? Beyond that, we have Wall Street creating funky yield vehicles that ~~gyp~~ facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.? Approach yield the way a businessman would.? If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.? At the end, privately, many scoffed, but I thought he was on the right track.? I still like dividends, but I like businesses that grow in value yet more.? Aim for good returns in cash generating businesses, and the dividends will follow.? Stretching for dividends is as bad as stretching for yield on bonds.? That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

Twenty-Five Ways to Reduce Investment Risk

Posted on 21 July 2007 by David Merkel

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
Avoid explicit leverage; don’t use margin.
Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
Avoid balance sheet complexity; it can be a cover for accounting chicanery.
Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
Avoid owning popular companies; they tend to underperform.
Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
Focus on industries that are out of favor, and look for strong players that can withstand market stress.
Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
Take something off the table when the markets run, and edge back in when they fall.
Analyze how any new investment affects your total portfolio.
Don’t use any investment strategy that you don’t fully understand.
Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
Size positions inversely to risk levels.
Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.