The role of dividends

Happy New Year! As I write this 2013 is coming to an end and 2014 is right around the corner.  Hopefully 2013 was a great year, and wishing that 2014 is even better.

I don't talk much about dividends on the blog mostly because I haven't thought much of them myself.  For a brief period of time, around 2006 I had a slight interest in dividend stocks and the concept of dividend growth stocks.  The idea is that investors look for companies that have grown their dividends at a high double digit rates for years and then invest in those companies for the dividend.  In theory the investor's income stream will continue to grow 10-15%; the company's dividend growth rate.  Dividend growth investors don't seem concerned about price appreciation, only dividend growth.

A disciplined and patient dividend growth investor might start a small portfolio in their 20s and by the time they're in their mid-60s have a sizable growing income stream they can use in retirement.

The concept is alluring and works well when modeled in Excel.  It also worked well over the past thirty or forty years.  The concept broke down for myself because I had trouble paying up for companies that had growing dividends.  My concern was that while a company might not cut their dividend in a recession their price could take a sustained hit.  Dividend investors are supposed to ignore price movements and focus solely on dividends.

The dividend growth model just never stuck with me, especially after a number of dividend growth stocks such as financials ended up cratering and cutting their dividends in 2008/2009.  Many dividend growth investors experienced a double whammy, no more dividends, and a reduced principle.

Value investors often seem to ignore dividends entirely.  Many value investors in the Buffett mold disdain dividends preferring companies to reinvest at high rates of return, or to buy back shares.  If a company can profitably reinvest their profits to fuel more growth at high rates it makes sense for them to reinvest.  Similarly share buybacks make sense if managers are able to acquire shares at low valuations in quantities that are meaningful, and don't issue options that offset the buybacks.

Unfortunately many businesses don't have great reinvestment opportunities, and managers aren't the best investors, often buying back stock with the price is high and failing to do so when the price is low.  I have talked with a number of executives who tout reinvestment, but when asked how they measure if their investments are successful suddenly become silent before admitting they have no way of measuring results.

My own approach of buying average or below average businesses at extremely attractive prices has resulted in a portfolio of companies that often should not be reinvesting in their business.  Many times management at these companies isn't familiar or comfortable with share buybacks either.  This means I've had to become comfortable with companies that pay back some, or a lot of their earnings as dividends.

My own view on dividends has changed through the years.  I started like most value investors, completely ignoring them, to shifting to an approach that appreciates and looks for them in certain circumstances.  Specifically I look for a company to pay a dividend when it is foreign, or unlisted.  If a company it is neither foreign or unlisted I am content to invest at an attractive valuation and let the market do its work.

The reason I want a dividend in an unlisted or foreign company is because value realization can take longer in those circumstances, and I want to be "paid to wait."

I've found that unlisted companies, and foreign companies also tend to pay out a larger proportion of their net income as dividends.  When one looks only at the price action of a company they miss a valuable component of return.  In my 2013 year end review two companies mentioned showed lower than realized performance because I didn't factor in dividends, Argo Group and Carlo Gavazzi.  In the case of Carlo Gavazzi their dividends added an additional 7.7% to their yearly performance.

A common complaint I receive about companies I write about on this blog is that there are no catalysts and it's painful to wait for the price to appreciate on its own.  One antidote to this thinking is to invest in undervalued companies that pay out dividends.  The dividends provide a built in level of return without a catalyst, or market price action.  Investors can receive high returns (often upwards of 8-10% in Europe) while they wait for the market to realize the undervaluation.

In this manner dividends can be viewed as an essential tool for hitting a yearly performance target.  If one has a goal of earning 15% returns from their portfolio, and the portfolio yields 5% then the portfolio only needs to appreciate 10% to meet the goal.  All things considered a 10% portfolio appreciation is easier to achieve than a 15% portfolio appreciation.

I don't believe companies paying significant dividends should be specifically sought out, but I also don't believe dividends should be entirely ignored.  Somewhere in the middle is a happy medium, a place where dividends are appreciated as a component of return.  I've come to appreciate them more over the years, and as one who invests in average businesses I'd prefer management give earnings back to me to reinvest rather than squander the earnings themselves.