Tuesday, December 22, 2009

Capital gains for dividend investors

The market is efficient enough sometimes to discount events and experience moves even before important pieces of information are distributed to all market participants. How many times have we seen a large increase in prices on above average volume for companies on virtually no news, only to find out that the company is going to be acquired at a hefty premium several days later?

At the end of the day, dividend growth investors expect that a company that regularly increases dividends would also lead to a higher stock price. This would leave current yields little changed for many years.

When the market goes up, 80%-90% of all stocks follow its moves. When it goes down 70% of companies go lower in tandem with it. While dividend investors do care mostly about stability and growth of their dividend income, capital gains are important as well.

While dividends have produced about 40% of average annual returns each year over the past 8 decades, capital gains are important as well. If investors believe that the company’s performance over time would improve, they would bid up the stock price. While the dividend payment would have increased roughly at the same rate as the growth in stock prices, the current yield could be unchanged. This would leave many novice investors wondering why anyone would waste their time and effort purchasing a stock which yields 2% - 4%, when other companies offer much higher current dividend yields. What they fail to notice is that the yield on cost on the original investment several years ago is much higher than the current yield.

If markets believed that the dividend growth is sustainable, the stock price would correct itself and bring the yield to about market level. This brings in some capital gains, which further compounds the wealth of the dividend investor. If investors as a group do not expect that the company’s dividend growth is sustainable, they would simply leave the price unchanged or lower over a period of time.

Mr market might be telling you something about a company that successfully increases its dividends while the stock price is down or flat. Let’s look at Pfizer (PFE). The company used to boast a record of 41 consecutive annual dividend increases. The pharmaceuticals giant cut its dividend in 2009, ending this streak. Investors might have expected that Pfizer’s long term position of a dividend growth stock is in jeopardy, as the stock price dropped from 50 to 13, pushing the yield to 10%. At the end of the day investors not only suffered from the reduced dividend income after the cut, but also from capital losses over the past decade.

A similar situation occurred with General Electric (GE), which also had a long streak of dividend increases, until it also cut its distributions in February 2009. The company’s stock price has had a rough decade, falling from 60 to 6 before partially recovering to 16. In the meantime the company’s current yield increased several times to over 10%, until the company cut its distributions by more than 60%. It definitely pays to listen to the collective wisdom of stock prices most of the times, although not at all times.

Procter & Gamble (PG) in the 1970s tells us a completely different story. The company had already established itself as a solid dividend achiever and kept rewarding shareholders with annual raises, while the stock price appeared uninterested in the general improvement of the company’s finances.

At the end of the day it is important to purchase the best dividend stocks that would throw off a rising dividend income stream. It is also important however to not completely ignore capital gains as well.
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