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Posted 10/17/2002













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The Speculator

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The Speculator
Higher dividends are no magic bullet
The market waters are murky when it comes to what dividends bode for stock performance. In 2002, the top 10 highest-yielding companies fared worse than the market -- by a good 10%.
By Victor Niederhoffer and Laurel Kenner

Dividends are good, and everyone wants them. That was the message we heard from thousands of readers who wrote in response to our report last week on the benefits of higher yields, dividend increases and repurchases. We also received thousands of requests for Paul DeRosa's article, which pointed out that based on earnings growth and earnings yield, the stock market was a good buy.

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Only John Clarke of Highland, Mich., exposed the irony of our turning to fundamental analysis. Vic's idée fixe, after all, has long been that the interactions between market prices alone are sufficient to generate profitable predictions. "The SPECULATOR talking about dividends as a valuable investment criterion! Now I know I'm in Kansas."

And one lawyer/CFA, whose name we withhold out of respect for his candor, suggested that a change in cycle may be imminent: "Have you considered comparing the excessive relative outperformance of the value style to the growth style? With all the 'dumb' money now chasing value (and bonds) one has to wonder what catalyst will cause a reversion away from said style of investment."

There's considerable wisdom in that observation, as we'll show below. By the time Vic and his ilk are ready to study value, chances are that tech will be back. Indeed, our Wednesday evening column was followed by a 13% rally in S&P 500 ($INX) futures over the next four days, but the Nasdaq Composite ($COMPX) was up 15%. We won't take credit for the rally after our bullish column, nor the declines that followed our June 13 "Invasion of the body snatchers" lament concerning the excessively bearish no-hope meme then making the rounds.

We'll give chapter and verse on dividends, as readers requested. But first, we'll start with some of the key insights we received in e-mail. As we discovered yet again, our readers collectively and individually know much more than we do. They each have their niches, their special areas of knowledge and attention. And by tapping into their wisdom we are able to provide an infinitely better column than if we tried to interview experts or relied on our own expertise.
    I thought your column today started to get at the heart of the problem in the market. If investors are not receiving tangible benefits from their stocks, like dividends or buybacks, then you have to invest on complete faith. Faith is fine during bull markets, but during bear markets, faith is lost. (David Shapiro)

    Until the stock market is straight with me, it's not getting any more of my money. And I'm not putting money in bonds now when they're at 40-year highs. Increasing dividends and eliminating the shenanigans you pointed out in your article would be a good way to mitigate risk and would make me take notice. (Carey Abbott)

    My father-in-law (now deceased) looked only at dividends for his personal support and never concerned himself with the value of his portfolio. He always talked about "getting raises." During market downturns, he worried not at all; he just didn't buy a new car or a new boat at those times. He only concerned himself with the security of the dividends. He retired at 50 and died at 90, having lived a very nice lifestyle, with a net worth that increased 10-fold during that period of investment. (Patricia K. Schwabacher)

    You can fake or inflate earnings, but if you pay out cash, you had to have it in the first place. (Paul Fels)

    Despite the tax disadvantage, dividend payments at least place control of the money with stockholders instead of the CEOs and their ineffective and all-too-compliant boards. (Ronald N. Woody)
An October 1998 study by the American Council for Capital Formation found that the United States taxes dividends more heavily than most other industrialized countries. In Taiwan, one of the great success stories of modern capitalism, the first $8,273 of dividends from local companies is tax-exempt. Some international readers rubbed it in:
    Given Canada's preferential treatment of dividends, we find many of the U.S. dividend-paying stocks very attractive at this point! (Chris Kaczur)

    In Australia, the Labour government during the 1980s abolished the double taxation of dividends … the result is that Australian companies pay some of the highest dividend yields in the world. (Jeremy Dunkel)
Richard Mark, a lecturer in finance at Dowling College, wrote that the main reason companies haven't been paying dividends is not the double tax, however, but a desire to retain earnings for misguided diversification projects, if not outright theft by senior managers. Some readers noted that there are ways of getting around the U.S. dividend tax with self-directed IRAs and New York Stock Exchange-listed Master Limited Partnership stocks.

Mopping up
Let's mop up -- one of the keys to victory in games, markets and research. We reported that companies that paid out a high yield relative to their price tend to outperform those that paid low dividends relative to price. The classic reference on this is in, as usually, that magnificent book, "Triumph of the Optimists," which we can never recommend too highly or too frequently. The authors show that a dollar invested in randomly selected U.S. equities at the beginning of 1900 comes to $16,800 at the end of 2001, but to only $2,000 without reinvested dividends.

Within that juggernaut of increasing wealth, the rewards from investing in high-yield stocks are superior to investing in low-yield stocks. In particular, the annualized yield on high-yield companies comes to 12.2% from 1926 to 2000, versus 10.4% for low-yield stocks. The difference of 2% per year has a large impact over the 74 years considered: $1 invested in the high-yielders comes to $5,000, versus just $1,500 for the low-yielders.

It appears, however, that the margin of superiority for high-yielders versus low-yielders has been close to zero since 1990. Thus, it seemed time for the Speculators to take the pencil to the envelope again and to update the dividend-yield-versus-return work for the 21st century.

Before entering into the nitty-gritty of what's been working and what hasn't vis-à-vis dividends recently, it's important to lay a foundation. An August article in the Journal of Finance by Gustavo Grullon of Rice University and Roni Michaely of Cornell University, covering 1980 to 2002, does this admirably. The authors show that as of the year 2000, stock buybacks became more important than cash dividends in terms of return to investors. They concluded that while stock buybacks are still more efficient than cash dividends because of the tax factor, they both signal efficient use of corporate funds by management. (Use the link at left to read the article.)

Furthermore, they conclude that the apparent superior performance that stocks have been showing vis-à-vis the cash dividends in recent years, even though cash dividend yields have been low by historic standards, is not anomalous at all. They conclude it is merely a reflection that many companies have replaced dividends with stock buybacks, and that taking account of the cash payout to stockholders from both sources, the valuation of stocks has been in line with traditional standards. However, they are silent on the question of whether buyback stocks or high-dividend-yielding companies show superior subsequent performance.

We considered the S&P 500 companies that showed the highest yields at year-end 2000 and year-end 2001, and their performance in the next year:

 Changing cycles: Performance of top 10 dividend-yield stocks (2001 vs. 2002)
Company Yield at yr-end 2001 2002 YTD performance Company Yield at yr-end 2000 2001 performance
Plum Creek Timber (PCL) 10.05 -27.1% Sabre (TSG) 12.06 -1.8
Dana (DCN) 6.77 -23.7% J.C.Penney (JCP) 10.47 155.79
Ford Motor (F) 6.68 -46.6% Rockwell Automation (ROK) 8.48 -15.51
J.C.Penney (JCP) 6.44 -45.5% Dana (DCN) 8.1 -3.34
Rockwell Automation (ROK) 6.34 -10.4% Ford Motor (F) 7.68 -29.27
CMS Energy (CMS) 6.08 -70.0% Deluxe (DLX) 7.33 116.65
Eastman Kodak (EK) 6.01 -10.8% Winn-Dixie Stores (WIN) 7.09 -23.52
Ameren (AEE) 6 -1.8% Thomas & Betts (TNB) 6.92 34.92
RJ Reynolds Tobacco (RJR) 5.86 -39.1% Wachovia (WB) 6.9 16.47
CenterPoint Energy (CNP) 5.66 -67.4% Southern Co. (SO) 6.6 31.95
Average -34.24% Average 8.16
Std Dev 23.59% Std Dev 1.77


Note that the top 10 high-yield stocks outperformed the market in 2001, with a positive return of 8%, versus a loss of 10% in the S&P 500 and a 39% loss in the Nasdaq. But in 2002, the effect has not held up: The top 10 high-yield stocks are down 34%. That's even worse than the 24% loss in the S&P 500, and exactly even with the 34% loss in the Nasdaq.

The numbers were similar for the top 30 high-yielders. These stocks were little changed in 2001, and are down 25% year to date.

Some particularly egregious examples of high-yielding stocks with disastrous returns in 2002 are listed below:

 High-yielding stocks with poor returns
Company Yield at year-end 2001 YTD performance
Allegheny Energy (AYE) 4.75% -87%
TXU Corp. (TXU) 5.09% -75%
Xcel Energy (XEL) 5.41% -68%
Allegheny Technologies (ATI) 4.78% -58%
Public Service Enterprise (PEG) 5.12% -32%


It's interesting to note that academic studies of the superior returns to high dividend-yielding companies find that the outperformance is particularly glaring in the month of January, but not so much in the other 11 months of the year.

No magic bullet
We turn now to the question whether dividend increases are good for performance. The academics have concluded that dividend increases are irrelevant. Recent studies from Finland to the United States have verified this. In the scientific tradition, we vetted their conclusions.

We looked at the 120 companies in the S&P 500 that increased their dividends in 2002. Their cumulative performance year to date is -14%. Twenty-two companies decreased their dividends, and their performance was -20%. This difference is significant at the usual statistical levels. Thus, dividend increases have been good in 2002.

Procter & Gamble (PG, news, msgs), Clorox (CLX, news, msgs), Meredith (MDP, news, msgs), Coca-Cola (KO, news, msgs) and Merck (MRK, news, msgs) were among the companies that did particularly well after raising dividends, with respective gains of 156%, 25%, 25%, 9% and 4%. We are not taking a position on these stocks, merely reporting what we found.

The great danger in buying high-yield stocks is that dividends may be cut. Look at what happened to the stocks of 14 S&P 500 companies that did so this year:

 S&P 500 companies with dividend cuts in 2002
Company Date of dividend cut Performance since dividend cut (%)
Ford Motor (F) 1/11/2002 -46
Dynegy (DYN) 8/12/2002 -45
Goodrich (GR) 5/17/2002 -45
Transocean (RIG) 6/14/2002 -43
Qwest Communications (Q) 6/24/2002 -42
U.S. Steel (X) 1/29/2002 -39
Millipore (MIL) 2/4/2002 -31
CenterPoint Energy (CNP) 8/8/2002 -25
Pall (PLL) 4/17/2002 -25
Xcel Energy (XEL) 9/26/2002 -23
CMS Energy (CMS) 8/1/2002 -17
Bausch & Lomb (BOL) 4/25/2002 -13
Winn-Dixie (WIN) 1/22/2002 25
Williams Cos. (WMB) 7/22/2002 45


Our results suggest that there is no magic bullet for stocks. High-yield companies seem to show superior performance over time, but that effect apparently vanished in the difficult year of 2002. Companies that increase dividends have had relatively woeful performance in the past, but in these times they augur good performance.

We previously reported that companies engaged in stock buybacks outperformed in all historical and prospective periods that we tested. We looked at it in early 2002, and the predicted outperformance did materialize. Perhaps we could attempt a synthesis.

How to know when the cycle will turn? We don't. Valuation, segment analysis and timing are all key to achieving superior returns. Like all things in life, there's no one path to glory.

Final note
In 1930s Los Angeles, corruption among police and politicians inspired film noir and a fiction genre of brilliant but moody detectives like Raymond Chandler's Philip Marlowe. Public revulsion against the mob eventually led to a top-down housecleaning. True-crime and detective stories like "Monk," "CSI" and "Crossing Jordan" are so hot on TV right now, that we wonder if they signal a new "lean and mean" regime where companies that produce low-priced, no-nonsense goods move into the fore. We see bullish signs, meanwhile, in forthcoming epic films on the ancient Greek heroes Achilles and Hector, the empire builder Hannibal and Patrick O'Brian's British Navy captain, Jack Aubrey. The emphasis on heroism signals a much more positive spirit toward achievement and enterprise.

At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned or controlled any of the securities mentioned in this article.




MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.