Vedran Vuk here, filling in for David Galland for the next couple of weeks. Today I'll discuss whether a company should be paying a dividend. If you're invested in high-yielding dividend equities, the first article is a must read. Next, Brandon Rowe, managing director of the International Man Network, will discuss important lessons from one of the first truly global investors, Sir John Templeton. Now, let's begin with dividends…
By Vedran Vuk
If you're in the market for a good dividend-yielding company, the search can be frustrating, to say the least. Though a stock screen of yields can give one a list of high-dividend companies, it can't tell us whether these dividends make sense. Many investors make the mistake of asking, "Does the company pay a dividend?" rather than the more important question, "Should the company be paying a dividend?"
Let's start with some basic financial theory on dividends: a company should only pay dividends when it has nothing better to do with the money. In other words, when the company sees no projects which can produce an exceptional return for investors. For example, should company XYZ payout $100 million from its earnings at the end of the year? Well, it depends. If the cash could be invested into a new project that could earn 25% by next year, the company should not give a cent to shareholders. If the project successfully earns the 25%, investors will be wealthier within a year without the dividends.
However, there is one exception to this guideline. If the investor can earn a greater return with less risk, then a dividend makes more sense. However, unless one has some inside information, most investors can't earn 25% with near certainty. But suppose the firm can only earn a 3% return on a prospective project. In that case, investors would be better off with a dividend. Anyone can stick dividends into a long-term bond and earn a greater return. So how do you figure all of this out? That's the hard part.
While dividend yields are easy to find on Bloomberg, Yahoo! Finance, and Morningstar, figuring out whether a company should be paying a dividend requires a closer look at its financial statements. There's no single ratio that reveals the answer, but there are a few short items which can point to red flags. Let's go through them:
1. The first thing to consider is the size and the nature of the company's business. If the company just bought a large sum of undeveloped acreage in the Bakken Shale – one of the most exciting oil plays in the country right now – it had better be spending every disposable dime in the budget to explore and develop the property. There's no reason to pay out dividends if the money can be placed into projects with high returns. On the opposite end of the spectrum might be a company like Coca-Cola; it's an enormous firm with a worldwide market. Coca-Cola is bringing in a significant cash flow, but the next investment opportunity might not be particularly obvious. Since Coca-Cola has spread so far across the globe, the next high-return project may be hard to find. The company may find itself with more money than prospective projects on the horizon.
Perhaps a new marketing campaign might work, but there are only so many marketing campaigns one can run per year. And yes, there are new markets to enter and perhaps acquisitions of other products, but even these opportunities will often fall short of justifying full reinvestment of earnings. In this case, it's better to give some money back to shareholders rather than spend funds on unprofitable "busy work," or leaving the cash to rot away from inflation in the company's accounts.
2. Check the payout ratio – it's the ratio of dividends to earnings in the most recent quarter or year. If the ratio is over 100%, this could potentially indicate a problem, as the company is paying out more than it is earning. In the long run, this isn't a sustainable dividend. However, on its own, a high payout ratio doesn't condemn a company. For the sake of consistency, firms will continue paying dividends in good quarters and bad. In fact, most investors want stable, long-term dividends. As a result, the company may pay its usual dividend in a period of low earnings, resulting in an abnormally high payout ratio. Hence, this is a red flag which can send the wrong signal.
3. How is the company's cash balance? There's no need for incredibly complex calculations here. How does the current year look compared to the last five? If there's a large stockpile of cash sitting around for a year or two, dividends might need to go higher. Furthermore, it's a sign that the company can more than afford its current dividend. On the other hand, if the cash supply is low, dividends might not be a good idea right now. Also, make sure to pay attention to the company's size. If the cash balance is the same as a few years ago, but the company's size has doubled, the cash balance as a proportion of assets has actually declined.
4. Where are the dividends coming from? It's one thing to continue paying dividends during a period of low earnings with a stockpile of cash; it's another matter to pay investors with borrowed money. The biggest red flag is a company using money from a recent debt offering rather than earnings to pay dividends. Think of it this way: the shareholder is actually paying interest on his own dividend. The investor gets the cash, but the interest payments on the debt reduce the value of his shares. On net, the shareholder is worse off than if the company had discontinued the dividend.
Each one of these tips has its own exceptions, but getting into the details would be far too much for this short article. However, these four factors should help one weed out the vast majority of companies that shouldn't be paying a dividend… or perhaps should be paying a bigger dividend. Remember that the size of the dividend doesn't matter. As a long-term yield investor, it's really the sustainability that matters. If a company pays too much in dividends, the company will slowly but surely wither away, and the capital depreciation will outweigh the once-attractive yield.
By Brandon Rowe
One could call me driven, ambitious, and determined. As a youngster, while most kids wanted to be firemen, astronauts, or policemen, I dreamed of being an entrepreneur and successful investor.
As you might imagine, I was seen as somewhat strange by most of my peers.
Unfortunately, I also came from a lower-middle class family, where entrepreneurialism and risk-taking were taboo. Going to school to get a good-paying job was the tried and true.
There were almost no real-life models for me to study. The only business owners I knew ran small, one-man shops where 80-hour weeks year in and year out were the norm. That's not what I wanted. A real entrepreneur builds a company, not just a job for himself.
So I began to study, focusing on just two simple questions:
While there seemed to be many reasons, one particular character trait stood out to me more than others.
It's one that most, if not all, successful entrepreneurs and investors share. They see the world not as how they wish it to be, but rather as it really is.
It's a simple observation that set one young man on a path that would earn him exceptional accolades…
In 1939, just as the Second World War landed on Europe's doorsteps, a 26-year-old American investor borrowed a then princely sum of $10,000 ($170,000 in today's dollars), in order to invest approximately $100 each in 104 Old-World companies. After holding those stocks for an average of just four years, he effectively quadrupled his money, netting himself a small fortune.
This was the start of nearly seven decades of successful investing that would see the young man from a poor family in Winchester, Tennessee, knighted by Queen Elizabeth, become a billionaire, and earn wide recognition as one of the world's foremost authorities on global investing.
His name? John Templeton.
Templeton can indeed be called the world's first global investor. Unlike many of his contemporaries (and indeed most investment gurus today), he did not restrict himself to looking for exceptional opportunities within one single market. Rather, he treated the whole world as his oyster – identifying the best opportunities wherever they might be.
To me as managing director of the International Man Network and publisher of the World Money Analyst, a new letter service designed to point investors toward global investment opportunities, Sir John Templeton is a phenomenal model from a professional point of view.
He's just as fascinating for his ability to predict the future with such amazing clarity, just as he did with the current crisis. All because he chose to see the world as it was.
In 2005, Templeton applied this simple philosophy to write was has become known as "Templeton's Last Testament." While he intended it to be published, it never was, only being found among his papers after his death in 2008.
Templeton's Testament concerns the state of the economy as it stood in 2005, or at least as our good knight saw it then. Now – almost seven years after he put pen to paper – it seems particularly prescient and is worthy of our attention. It follows [Editor's Note: Underlining is his].
John M. Templeton
Lyford Cay, Nassau, Bahamas
June 15, 2005
Financial Chaos – probably in many nations in the next five years. The word chaos is chosen to express likelihood of reduced profit margin at the same time as acceleration in cost of living.
Increasingly often, people ask my opinion on what is likely to happen financially. I am now thinking that the dangers are more numerous and larger than ever before in my lifetime. Quite likely, in the early months of 2005, the peak of prosperity is behind us.
In the past century, protection could be obtained by keeping your net worth in cash or government bonds. Now, the surplus capacities are so great that most currencies and bonds are likely to continue losing their purchasing power.
Mortgages and other forms of debts are over tenfold greater now than ever before 1970, which can cause manifold increases in bankruptcy auctions.
Surplus capacity, which leads to intense competition, has already shown devastating effects on companies who operate airlines and is now beginning to show in companies in ocean shipping and other activities. Also, the present surpluses of cash and liquid assets have pushed yields on bonds and mortgages almost to zero when adjusted for higher cost of living. Clearly, major corrections are likely in the next few years.
Most of the methods of universities and other schools which require residence have become hopelessly obsolete. Probably over half of the universities in the world will disappear quickly over the next thirty years.
Obsolescence is likely to have a devastating effect in a wide variety of human activities, especially in those where advancement is hindered by labor unions or other bureaucracies or by government regulations.
Increasing freedom of competition is likely to cause most established institutions to disappear with the next fifty years, especially in nations where there are limits on free competition.
Accelerating competition is likely to cause profit margins to continue to decrease and even become negative in various industries. Over tenfold more persons hopelessly indebted leads to multiplying bankruptcies not only for them but for many businesses that extend credit without collateral. Voters are likely to enact rescue subsidies, which transfer the debts to governments, such as Fannie May and Freddie Mac.
Research and discoveries and efficiency are likely to continue to accelerate. Probably, as quickly as fifty years, as much as ninety percent of education will be done by electronics.
Now, with almost one hundred independent nations on earth and rapid advancements in communication, the top one percent of people are likely to progress more rapidly than the others. Such top one percent may consist of those who are multi-millionaires and also, those who are innovators and also, those with top intellectual abilities. Comparisons show that prosperity flows toward those nations having most freedom of competition.
Especially, electronic computers are likely to become helpful in all human activities including even persons who have not yet learned to read.
Hopefully, many of you can help us to find published journals and websites and electronic search engines to help us benefit from accelerating research and discoveries.
Not yet have I found any better method to prosper during the future financial chaos, which is likely to last many years, than to keep your net worth in shares of those corporations that have proven to have the widest profit margins and the most rapidly increasing profits. Earning power is likely to continue to be valuable, especially if diversified among many nations.
It's amazing how accurately some of his predictions are. But what can we take from all this?
First, it's clear to all but the most muddle-headed that the old investment strategies simply do not work in today's world. It used to be that government bonds and savings accounts were a satisfactory way to build a respectable level of wealth over time.
However, with many governments now printing massive amounts of currency (causing inflation), as well as the yields on many rich-world government bonds at all-time lows, such a strategy is about as practical as selling blocks of ice to the Inuit.
Succeeding in today's environment requires one to go where the opportunities really are, no matter where they are. Someone trapped in the thinking of the "single-market investor" – especially those in Western countries plagued by high debt, low growth, and poor-demographics – are going to have an extremely hard go at it.
On the other hand, maintaining an international perspective to investing is more likely to pay huge dividends, not only in cash but – if properly structured – in portfolio security and stability as well.
Second, the rate of change in everything from technology to social issues is picking up pace – led primarily by technology. Templeton had the luxury of an exceptionally long life in an era that saw the fastest technological progression in the history of the planet. He was able to see firsthand the development of many of the technologies we now take for granted (and their pleasant and unpleasant side effects).
Science progresses even faster today, and no doubt it will dramatically reshape the way we interact with the world as well as how the world interacts with us. The process will likely create chaos and destroy institutions that were once considered "indestructible."
In such an environment, just preserving capital will be hard enough, let alone trying to grow it. But, at the same time, it will also create once-in-a-lifetime opportunities for savvy investors who can identify and act on those opportunities.
The key, as in the point above, is that those investors who are comfortable thinking globally are the ones most likely to benefit. While some of the best opportunities over the coming years might be found in the US, such happy occasions are likely to be far and few between. More likely, they are to be found elsewhere – in Asia, South America, or even the periphery of Europe hammered by the euro crisis. (In fact, we recently identified one company in the PIIGS with extremely favorable fundamentals trading at just a P/E of 3. It also paid a 12% dividend last year.)
Third, even at 92 years of age, Templeton absolutely hit the nail on the head. If one person can see it, others can too. Successful investing is simply a matter of identifying and listening to those who do get it.
There's no doubt about it: we are living in very interesting times. It's going to be full of hardship for many. It's a time when the ignorant will likely be washed away in the current economic hurricane.
But if we learn and follow the lessons of those who have gone before us – those who choose to see the world as it truly is – we are much more likely to not only survive, but thrive… and perhaps create a fortune or two of our very own.
[Brandon Rowe is the managing director of the International Man Network and publisher of World Money Analyst, a new global investment newsletter that lets readers learn and profit from a group of successful, geographically diverse investors and analysts who discover and report on undervalued opportunities in different markets each and every month. A limited-time Charter Subscriber offer is available – the first issue is free with 90% off the first year's subscription rate and a full money-back guarantee.]
A Cowboy Named Bud
A cowboy named Bud was overseeing his herd in a remote mountainous pasture in California when suddenly a brand-new BMW advances toward him out of a cloud of dust.
The driver, a young man in a Brioni® suit, Gucci® shoes, RayBan® sunglasses, and YSL® tie leans out the window and asks the cowboy, "If I tell you exactly how many cows and calves you have in your herd, will you give me a calf?"
Bud looks at the man, who obviously is a yuppie, then looks at his peacefully grazing herd and calmly answers, "Sure, why not?"
The yuppie parks his car, whips out his Dell® notebook computer, connects it to his Cingular RAZR V3® cell phone, and surfs to a NASA page on the Internet, where he calls up a GPS satellite to get an exact fix on his location, which he then feeds to another NASA satellite that scans the area in an ultrahigh-resolution photo.
The young man then opens the digital photo in Adobe Photoshop® and exports it to an image processing facility in Hamburg, Germany.
Within seconds, he receives an email on his Palm Pilot® that the image has been processed and the data stored. He then accesses an MS-SQL® database through an ODBC connected Excel® spreadsheet with email on his Blackberry® and, after a few minutes, receives a response.
Finally, he prints out a full-color, 150-page report on his high-tech, miniaturized HP LaserJet® printer, turns to the cowboy and says, "You have exactly 1,586 cows and calves."
"That's right. Well, I guess you can take one of my calves," says Bud.
He watches the young man select one of the animals and looks on with amusement as the young man stuffs it into the trunk of his car.
Then Bud says to the young man, "Hey, if I can tell you exactly what your business is, will you give me back my calf?"
The young man thinks about it for a second and then says, "Okay, why not?"
"You're a Congressman for the US government," says Bud.
"Wow! That's correct," says the yuppie, "but how did you guess that?"
"No guessing required," answered the cowboy. "You showed up here even though nobody called you; you want to get paid for an answer I already know, to a question I never asked. You used millions of dollars' worth of equipment trying to show me how much smarter than me you are; and you don't know a thing about how working people make a living – or about cows, for that matter. This is a flock of sheep."
"Now give me back my dog."
That's it for today. Thank you for reading and subscribing to Casey Daily Dispatch. See you again next week.
Casey Senior Analyst