The Dividend Conversation
When we speak about how we invest, we often get questions about dividend-paying companies and if we invest in them in our clients’ portfolios. We can understand the affinity to such companies. Dividend-payors can be perceived as higher-quality because of their income streams to shareholders. In fact, some dividend-payors have 40+ years’ of track records issuing dividends. Unfortunately, most people don’t know what a dividend is, why a company decides to issue one, and what the cause and effect to the company can be if it decides to issue a dividend.
A dividend is a distribution from a company’s net income and is paid out to shareholders. It is typically issued on a quarterly basis but can also be done ad-hoc. A company typically decides to issue a dividend to their shareholders when it feels that investors can attain a higher return versus the opportunities available to the company. We say “typically” as this isn’t always the reason why management decides to issue a dividend.
Cause and effect of issuing a dividend to the company and investors.
An example of a classic dividend-payor is General Electric (“GE”). They have issued a dividend for the last 119 years. The dividend yield is the annual dividend per share divided by the price per share. GE’s annual dividend per share, on a trailing-twelve-months basis is $0.37 and it’s price per share, as of 2/5/19’s closing price, is $10.63. Its dividend yield is calculated as follows: $0.37 / $10.63 = 3.48%.
There are a couple points we want to make here. First, the dividend yield can fluctuate based upon what price per share you pay to own the stock’s shares. Hence, if you pay a higher price per share, your yield will decrease and vice versa. Historically, investors have compared prospective dividend yield returns to what they can receive from owning a 10-year Treasury bond bought at par as it is one of the lowest-risk investment securities in the world. So, using the aforementioned calculation, if the 10-year Treasury yield is >3.48%, an investor should buy the 10-year Treasury and if the dividend yield is greater than the 10-year Treasury yield, the investor should buy the company’s stock. Due to countries’ central bank machinations during and after the Great Recession, which included lowering interest rates and Quantitative Easing (“QE”), investors who used to look for assured income streams in the fixed income space, like those 10-year Treasuries, had to begin searching elsewhere. The result: investors began looking for higher yields from dividend-payor stocks.
This leads us to our second point. Most investors don’t consider the impact to their investment in a dividend-payor’s stock if the stock’s price decreases. Using our GE example, if you buy the shares at 2/5/19’s closing price of $10.63 and a year later (2/5/20), its price has decreased by 20% to $8.50, your investment will have a total loss of -16.52% (3.48 + -20.00% = -16.52%)! This becomes a real risk if you decide to sell and realize your losses. The advantage of investing in fixed income securities was, so long as an investor held until maturity, they would receive their original investment back, after having received a steady income stream from the interest payments. So, using our example above, it might have been worthwhile for the investor to invest in the 10-year Treasury rather than GE’s stock because of the almost-certainty of receiving their original investment back.
GE: what came to pass
We used the example of GE because it was an excellent example of why an investor shouldn’t buy stock solely because it was a dividend-payor. GE has been forced to cut its dividend twice in the last 10 years; once in 2009 and again in 2018. The last cut in 2018 cut the quarterly dividend from $0.12 to $0.01. That means its annual payout has decreased from $0.48 per year per share to $0.04! With our dividend yield example above, the $0.37 quoted was a combination of the first dividend cut to $0.01 and the prior three quarters’ payout sum of $0.36, which yielded the 3.48% yield on GE’s stock. Instead, the investor is getting a forward yield of 0.38%! If an investor had purchased GE shares on 7/27/09, the day GE’s first cut dividend was paid to shareholders, and held till 2/5/19, their annualized return, with dividends reinvested, would be 1.61%. Amazingly, an investor’s return if they had not reinvested the dividends would be higher at 3.65%!
GE had to cut its dividend due to poor capital allocation over the past couple of decades, which included overpaying for acquisitions, liabilities generated in its GE Capital segment, and poor employee incentives. Instead of reinvesting in its business, GE chose to maintain and increase its dividend payouts to please its shareholders. It was forced to cut its dividend in 2009 due to the Great Recessions’ impact on its GE Capital segment and in 2018, its problems finally manifested themselves resulting in the latest cut to $0.01 per quarter per share. Those investors drawn to GE because of its 119-years dividend-paying history suffered as the dividend cut hit their income stream and the stock price decrease delivered capital losses.
Berkshire Hathaway, Class B shares (“BRK.B”): an example of excellent capital allocation
There are examples of excellent capital allocation out there for investors to invest in. The one that easily comes to mind is BRK.B and its CEO Warren Buffett. If you had invested in BRK.B during the same period, you would have achieved an annualized return of 13.40%. And this was without receiving one dividend! Buffett managed this by following the basics of capital allocation, that is, where can he find the highest return for BRK.B’s earnings versus returns available to BRK.B’s investors elsewhere? This is how a CEO should think about their company’s earnings, in order of priority:
Can they reinvest in their company’s current business(es)?
Can they invest in adjacent or unrelated business(es)?
Can they acquire new companies?
Should they keep the cash to invest in opportunities as they arise?
Return capital to shareholders via share repurchases
a. If the company is unable to purchase shares at a higher return than available to their shareholders investing elsewhere, issue dividends
Here’s the point we’re trying to make: dividends are only one piece of the capital allocation puzzle and the lowest-ranking piece at that. Investors focus on dividends because they are tangible and a short-term return on their investment. However, companies can create more value by reinvesting in their current business(es) or adjacent business(es) before they even think about issuing a dividend. For investors, that can be an issue because it’s harder to see and it can take many years for the investment results to be reflected in the company’s stock price. If GE’s management had been doing their job properly, they would have been more focused on reinvesting in their company and not overpaying for acquisitions. They failed, and as a result, their shareholders are suffering the consequences. GE, and other examples like it, are why dividends are not the principal factor that LBW considers when we invest our clients’ funds.
 https://www.investopedia.com/terms/p/parvalue.asp: “Par value is the face value of a bond.”
 A couple of clarifications and assumptions: this is assuming the bond is bought at par value, that is, if the bond was issued at $100/bond and the investor bought the security for $100/bond. So long as the investor buys at or below par value, they will earn a return equal to or greater than the bond’s yield.
 Again, provided they purchased the bond at par value.
 If you had invested in Class B shares, your return would actually be slightly lower at 13.15%.