Dividend Based Investing

Unkindest cut of all: Dividends may not mean all that they used to

By Mark Hulbert, MarketWatch
Last update: 12:01 a.m. EDT Sept. 24, 2008

ANNANDALE, Va. (MarketWatch) -- One of the totally unintended consequences of the financial crisis over the past year is to show us just how much companies hate to cut their dividends.

Of course, we've always known to some extent that companies like to avoid such cuts.

But the lengths to which they will go to avoid cutting has become clear in the behavior of some financial companies over the last year: They not only are willing to maintain their dividends in the face of losing huge amounts of money, they sometimes will even increase them.

I owe this insight to Peter Bernstein, the famous author and financial historian whose impressive investment career has spanned some seven decades. In the latest issue of his institutional newsletter, Economics and Portfolio Strategy, which I received Tuesday, Bernstein focused on earnings and dividends at several noteworthy financial firms.

In particular, Bernstein focused on "five of the most famously wounded soldiers of recent battles:" Fannie Mae (FNM) , Freddie Mac (FRE) , Lehman Brothers Holdings Inc. (LEH) , Merrill Lynch & Co., Inc. (MER) , and Citigroup, Inc. (C) .

Consider Fannie Mae (FNM) , whose financial losses have been steadily mounting for some time -- losses which hit such a crescendo earlier this month that the Federal government decided to bail it out. Why, Bernstein asked, was this or any of the other financial firms he looked at, "paying any dividend at all in 2008"?

Bernstein focused on more than just the last couple of quarters, furthermore. Consider the earnings per share and dividends at Fannie over the past 10 quarters, as Bernstein presents them in the latest issue of his newsletter.

As Bernstein commented about his five financial companies: "The money to pay the dividends had to be borrowed or [they] drew down previous cash."

In addition to the crucial questions Bernstein asked, I think the data he presents also help to explain why companies over the last couple of decades have increasingly chosen to use excess cash to repurchase shares. The marketplace is punishing companies, to a greater extent than ever before, for cutting their dividends. So a company's board of directors won't increase its dividend unless it is pretty darn sure that it can maintain that dividend for the foreseeable future -- and, by the same token, will not cut its dividend unless hope is pretty much all lost.

If a company today finds itself with extra cash, therefore, and wants to return that cash to shareholders, it is far more likely to repurchase some its shares in the open market than to increase its dividend.

This state of affairs both increases the attractiveness of strategies that pick high-yielding stocks, while simultaneously highlighting those strategies' risk. That's because a stock's high yield can come down for two reasons: One is for the stock price to go up, but the other is for the dividend to be reduced.

Over the short-term, at least, investors purchasing high-yield stocks probably can feel more confident than before that companies' obsession with not cutting a dividend will remove this second way for yields to come down.

Over the longer-term, in contrast, investors probably need to have less confidence than before that a company's dividend is a signal of management's confidence in its long-run earnings power.

The newsletter I follow that it is the purest play on high-yield strategies is probably Investment Quality Trends, edited by Kelly Wright. He helps immunize himself from these longer-term risks by focusing only on high quality blue-chip stocks -- those that are in relatively sound financial condition.

Wright does this by requiring the stocks on his watch list to satisfy at least five of the following six conditions:

• Dividend increases five times in the last twelve years
• S&P Quality ranking in the "A" category
• At least 5,000,000 shares outstanding
• At least 80 institutional investors
• At least 25 years of uninterrupted dividends
• Earnings improved in at least seven of the last 12 years

This method historically has served the newsletter very well, as evidenced by its being one of the top performing over the long term of any tracked by the Hulbert Financial Digest. But even it has not been immune to the ravages of the financial panic in recent months: At the beginning of September, its model portfolio included American International Group, Inc. (AIG) , Fannie Mae, Citigroup, and Merrill Lynch.

It's a brave new world out there, even for the supposedly bluest of the blue chip stocks.

"Stick with the highest quality," Wright emphasizes in his latest issue.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

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