Dissent on Dividends

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.