Dividends are the key to a sensible investment strategy

Dividends are the key to a sensible investment strategy
As we entered 2009, no one would have predicted the strong rally in the FTSE 100, which is now up 22pc as we approach the end of the year.

By Garry White
Published: 7:32PM GMT 26 Dec 2009

In fact, sentiment was so grim that the FTSE 100 fell by almost a quarter over the first three months of 2009.

Questor has therefore been particularly defensive over the last year and focused on yield plays, recovery shares and defensives. This strategy has proved sound, with some real successes, although there have been one or two less than perfect calls along the way.

A dividend strategy should be the cornerstone of any sensible investor's portfolio. Various studies have suggested that more than 70pc of the long-term return in a portfolio is generated by reinvested dividend payments. In the UK we have some of the highest-yielding shares in the world – and UK investors should continue to exploit this.

Yield plays over the last 12 months include National Grid, Northern Foods, Imperial Tobacco and Primary Health Properties. All of these shares remain buys as we enter 2010.

The mining sector has proved lucrative as commodity prices jumped after being oversold last year. The falling dollar has boosted the price of basic materials significantly, as a falling dollar makes them attractive to investors in currencies other than the dollar. Vedanta (up 368pc), Centamin Egypt (up 191pc), Petropavlovsk (up 67pc) and Randgold Resources (up 38pc) have been notable success. A buy stance remains on Russian gold miner Petropavlovsk and Egyptian gold miner Centamin. However, Questor did tip South African ferrochrome producer International Ferro Metals at the wrong time and the shares have plunged by more than 50pc.

Investments in the oil sector have also proved good investments, including Tullow Oil, Afren, BP and Dana Petroleum. The oil services sector has proved even more lucrative, with shares in Petrofac up 116pc and Cape shares up 226pc. The stance on Petrofac shares is hold and Cape shares remain a buy.

It was not all a success, however. A bet on the direction of the oil price using an exchange-traded fund in the earlier part of 2009 proved disastrous – and led to a 30pc loss. All these shares except for Tullow remain a buy.

Next year prospects look brighter than they did 12 months ago, but there is still scope for substantial upset. Dubai World's bond default is a recent example of the potholes that could be faced by investors next year – and the chances of a double-dip recession are very real. Questor has said on a number of occasions that he would not start to become more positive on the outlook until global unemployment started to fall. There has been scant evidence of this so far.

One thing investors should bear in mind next year is that the FTSE 100 is not a reflection of the UK economy – and that's why it should do quite well. About 30pc of the index's weighing is comprised of commodity-related plays such as mining and oil and gas groups. These shares will be influenced by changes in global GDP and prospects for the dollar. The FTSE 250 is by far a clearer reflection of what is going on in UK industry. If the UK economy starts to get back onto its feet, it should be positive for this index.

One sector that should continue to perform is the outsourcing sector – no matter which party wins the election in the first half of the year. In his pre-Budget report, Alistair Darling said: "We will sell those assets that can be managed better by the private sector." As governments all over the world strain to cut debt, this trend will be global and will be around for many years to come.

Over the past year Questor has recommended a number of outsourcing groups and still has buy ratings on Serco, Capita and VT Group.

Questor will reveal his tips for 2010 in The Daily Telegraph on Monday, January 4.

http://www.telegraph.co.uk/finance/markets/questor/6890986/Dividends-are-the-key-to-a-sensible-investment-strategy.html

Choosing the Right Tools

You can't have everything.  Where would you put it?

Imagine walking into a home improvement superstore with only a vague idea of what you want to buy.  You could spend hours wandering up and down aisles looking for the right tools.

Investments are tools you use to achieve your long-term financial goals and choosing the right tools is critical to your success.  The universe of possible choices is huge.  There is a virtual superstore of more than 2,800 companies listed on the New York Stock Exchange, nearly 3,500 listed on the Nasdaq and thousands more listed on other exchanges in the US and around the world.  In addition to stocks, there are:

• commodities,
• real estates,
• bonds,
• annuities,
• options,
• hedge funds,
• mutual funds,
• futures contracts, and on and on.

One of the beauties of investing for dividends is that you can limit your search to just stocks - and to just those stocks that pay dividends.

How do you conduct your search?

How you conduct your search will play a large part in how many stocks you'll be able to choose from. 

• If you're using a computer, you may be able to access, download, or process thousands of potential candidates. 
• If you're conducting your search by hand, you may be looking through the stock listings in the newspaper with a highlighter. 

In either case, your goal is the same:  to find a manageable list of stocks that meet your initial criteria. 

Over time, these will become familiar friends.  By tracking their fortunes over the years, you can gain a solid understanding of their underlying value and potential future prospects.

Three distinct yield categories of stocks

Income investors should focus their search on dividend stocks that have yields high enough to generate the income they require.  If you need an income stream equal to 4 percent of invested capital, then you should look for stocks with yields int he 4 percent range. 

There are thousands of stocks, so to make your job of finding the right dividend stocks easier, we suggest you mentally group them into three distinct yield categories:

Category 1:  Low-yielding stocks
These are issues that have a dividend yield of less thant he yield of the S&P 500 Index.  The yield on the S&P 500 Index is about 1.5%.

• Although they do pay a dividend, they tend to reinvest most of their earnings to foster growth in value through price appreciation. 
• These stocks are very appropriate for growth investors, but they may fail to meet your income requirement.

Category 2:  Medium-yielding stocks
These are issues with dividend yields that are equivalent to the index's yield or higher and tend to be companies focusing on providing a balanced return from both dividends and price appreciation.

• When screening for stocks, we target stocks with yields that are at least 150 percent of the index's yield.  They are committed to their dividend program and pay out from 30 to 50 percent of earnings in dividends. 
• You can shop in this group for income, but remember that the object of your search is to find stocks that meet your income requirement, so you should concentrate on stocks with higher yields.

Category 3:  High-yielding stocks
These are issues with yields today in the 4 to 5 percent range or higher and are companies that are generally in mature industries that focus on providing investors with returns through dividends. 

• They pay out 50 percent or more of their earnings to attract investors to their high dividend yield.
• Mature industries that fit this category are utilities, banks, pharmaceuticals, energy and real estate investment trusts (REITS).  The high yields of REIT stocks can be compelling.
• You will be able to find a fair supply of high-yielding stocks with dividend yields equivalent to most bonds' yields.  It just depends on where you look. 
• You can find stocks with yields in excess of 4 percent from mature companies in certain industries like utilities that focus on attracting investors to their high dividend yields.
• You can also find undervalued stocks with juicy yields that have fallen out of favour with investors.  In many cases, their price has declined while their dividend has remained stable, increasing the stock's yield in the process.  Analyse these situations carefully to determine why the stock has declined in price and if its dividend is secure.  There is often a fundamental business reason why the stock price is declining:  failing to meet earnings expectations, declining revenue, increasing debt levels, etc.  Your job is to determine if the price decline is a temporary setback or part of a larger negative trend.  If you're confident that the pricing adjustment is based on temporary conditions that you see improving, then you may have found a nugget of gold!

Evaluating Dividend-Paying Companies

A company should be evaluated on three dividend attributes:

1.  Reliable dividend payment history
2.  A record of increasing dividends
3.  A relatively high dividend yield

A company's dividend history is factored into the company's stock price. 

• One with a superior history of paying and increasing dividends will usually command a higher price than a company that has a poor record. 
• A high dividend yield will often attract more investors to a stock, and this can translate into higher prices as investors buy up shares to lock in a generous stream of dividends.
• A track record of dividend growth is an important indication of the company's ability to grow earnings. 

But beware of company with a high dividend yield that has an eroding earnings outlook.  Remember, a company can only pay dividends from current or accumulated earnings.  Without good earnings, there is good chance that the high dividend you covet may be cut.

What dictates dividend policy?

Management determines if it is going to distribute earnings in the form of a dividend or reinvest all earnings to further the business plan of the company.  The ratio of dividends paid out to investors versus the amount of earnings retained is called the payout ratio.  Changes in tax law and investor preference can influence decisions in the corporate boardroom regarding how much profit to retain or to pay out to investors in the form of dividends.  However, dividend increases often lag behind an increase in earnings because management will want to be certain that a new higher dividend payment will be sustainable going forward.

Looking back over market history, we can see that dividend policy and payouts have remained relatively steady and that any change in dividend yield has had a lot more to do with the change in stock prices than with changes to dividend policy made by corporate directors.  (Note:  You can 'price' your stocks by looking at historical dividend yields.)

Management is usually very reluctant to reduce dividends because a cut is often perceived as a sign of financial weakness.  Even during the Great Depression, companies were loath to cut dividends.  From 1929 to 1932, dividend yields soared because most companies maintained their dividends as stock prices collapsed in the crash.  But, as stock prices rose from 1933 to 1936, dividend yields fell - even though companies were actually increasing the dividends they paid.

This inverse relationship between dividend yield and price was really evident during the huge bull market run from 1982 to 1999.  Companies increased dividends steadily over the period, actually increasing dividends paid by almost 400 percent.  Yet the dividend yield collapsed to historic lows because stock prices increased by 1,500 per cent.

Some companies do run into trouble and cut or omit their dividend payments, but this is the exception rather than the rule. 

• The typical dividend-paying company not only maintains the dividend payout it establishes, but follows a policy of steadily increasing its dividend as earnings increase. 
• Some companies increase their dividend payments every quarter, some once per year, and others only as profits allow. 
• Some companies will even pay extra or special dividends if earnings have been quite good for a number of years.

Many established public companies pay cash dividends and have a dividend policy that is well known to their investors.  Some of them have been paying cash dividends for a very long time.

Twelve of the companies in the S&P 500 today started paying dividends more than a century ago.

S&P 500 Century Dividend Payers

Company ----  Cash Dividends Paid Each Year Since
Stanley Works ----1877
Consolidated Edison ---- 1885
Lilly (Eli) ---- 1885
Johnson Controls ---- 1887
Procter & Gamble ----1891
Coca-Cola Co ---- 1893
First Tennessee National ---- 1895
General Electric ---- 1899
PPG Industries ---- 1899
TECO Energy ---- 1900
Pfizer. Inc. ---- 1901
Chubb Corp ---- 1902
Bank of America ---- 1903

Price and Dividend Growth Trends of Share

Esso

in 1975
$1.5 Per share

end of 1983
$12.7 Per share

Capital gain
747%

Malayawata

in 1975
$1.5 Per share

end of 1983
$2.32 Per share

Capital gain
55%

Why is there such an enormous difference in the capital gain?

http://spreadsheets.google.com/pub?key=t43WD4CWVAy-DW46q0q892Q&output=html
 
 
What can we learn from the above table?
 
1.  We can see that both shares seem to sell at prices which fall within a range of dividend multiples which is fairly stable for each of the shares.   

• If we ignore the freak year of 1975, Esso appears to sell for a price that is between five and eleven times its dividend. 
• Malayawata, in contrast, seems to sell at a price that is between fifteen and forty times its dividend, except for the freak year of 1981. 

 
2.  We can see that the occasional freak year can take place when the prices move well out of the normal range.  

• In 1975, Esso was selling at a price that was far too low by its historical standard. 
• In 1981, Malayawata was selling at a price that was far too high.
• In the event, both prices have corrected themselves and moved back into the usual range within a year.

 
3.  We can see very clearly that the sharp increase in the price of Malayawata during 1981 was almost certainly due to speculation or manipulation. 

• The price rise could not be sustained in the absence of a big increase in dividend and the price fell back very sharply. 
• In sharp contrast, the price of Esso could be sustained even though the overall market dropped.  This was because of the very high dividend which was being paid out.

 
4.  We can see quite clearly that the Malaysian/Singaporean stock market is not an efficient one (i.e. one which prices shares correctly). 
 

• By all usual standards, Esso is a far superior company compared with Malayawata and yet, it continuously sells at a dividend multiple that is well below that of the latter.  
• This is very strong evidence that Malaysian investors do not always consider the fundamentals when purchasing shares.  To them, the stock market is more a place for a gamble than an investment.

 
5.  In eight years, the DPS of Esso increased from 18 cents to 140 cents, an increase of 678%.  It experienced an increase in the share price of about 747%.  This means that, nett of the dividend effect, the price of Esso went up by about 70% for the period examined.
 
In contrast, there had been a decrease in the DPS of Malayawata of about 25% and the price went up by about 55%.  This means that the nett of the dividend range, there was a price increase of 80%. 
 
This is roughly in line with the increase experienced by Esso after the dividend effect has been excluded. 
 

• Thus it is clear that dividend increase accounts for much of the price increase experienced by Esso while some other factors account for a small part of the increase. 
• Although Malayawata has experienced no increase in dividend, its price went up nevertheless due to the same factors which caused Esso price to go up more than the increase in dividend. 
• As to what factors these are, we are not yet in a position to answer.

 
Conclusion:
 
A careful study of the table provides evidence that the long term growth in a share's price is closely related to the amount of dividend it pays out. 
 
Over the short run, there may be temporary market aberrations which cause the price to reach unreasonable levels. 
 
But such madness is usually of short duration and within a year or two, the price will go back to its usual level.
 
 
Ref: 
Stock Market Investment in Malaysia and Singapore by Neoh Soon Kean