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Monday, November 30, 2009

Don't Forget About Dividends - Critical for Total Return Over Time

In our "How's the Economy Doing" update the other week, we mentioned our preference for owning franchise type businesses that are currently generating significant excess cash flow and have limited to no debt. In addition, we again noted a preference for paying low multiples of current earnings and growth. We should add a third component: dividends.

In November 2008, we mentioned to friends and family that a dividend strategy was an important part of our overall, two-pronged portfolio strategy:
  • (1) Focus on defensive names/sectors with stable dividends since income is more certain and capital gains are uncertain, at least in the short-term. These types of businesses have not been immune to the current market swoon, but – in our view – are more likely to outperform as investors gravitate toward their relatively steady operating profiles.
  • (2) Focus on secular growth companies that pay no cash dividends yet have healthy net cash positions, limited to no debt, and a history of large free cash flow that should continue even in a down economy. With everyone clamoring for cash, owning franchise type businesses that (1) have net cash and (2) generate significant excess cash arguably appear as attractive as simply holding cash, in our view, particularly given extremely high earnings and free cash flow yields.
An 11/06/09 article in Fortune, "Go the distance - Dividends for the long run", emphasizes the importance of dividends and what to look for in researching dividend paying companies:
  • Some companies maintained or raised them in the past year, indicating that their payouts can survive even the worst markets. And dividend investing remains a sound course amid market turmoil. Ned Davis Research shows that since 1972, companies that increase or begin paying dividends have returned 9.5% a year, soundly beating the 6.8% return of the S&P 500.
  • So how do you find income stocks you can count on? Ideally you want established companies that have a long history of dividend increases.
  • You also want to look at the coverage ratio -- earnings per share divided by the dividend per share. A figure of two or higher tells you the company has plenty of money to pay its dividend. (Companies with lower coverage ratios can also be steady payers if they have stable cash flows.)
The above graph tells the story. While we suspect that what we'll call reverse-survivorship bias may impact the "green" group in the graph (i.e. successful non dividend paying companies are gobbled up by larger companies, leaving underperforming companies in the green group), the outperformance of dividend paying stocks is noteworthy. Of course, the compounding power of dividends may explain the majority of the large delta.

We mentioned a position in REIT preferred equity last week. Next month, we may share certain companies we own that pay healthy dividends.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
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