VALUE INVESTING
Dividend Power

By Stephen Bland (TMFPyad)
May 17, 2002

I have never understood those people who claim that companies should pay less, or even no, dividends. It actually staggered me, way back in the early days of TMF here, that there was an official campaign by the site to try and persuade companies to cease paying dividends. It had absolutely no effect thank goodness. I never thought it would but the motivation behind it worried me at the time.

Mind you if I recall correctly this was in the days when so-called growth shares were just about the only thing that was discussed much around TMF and we all know (at least value players do) what happens to growth shares in a very large number of cases. The believers in lack of dividend feel that the company can make better use of the money than the investor so that their growth shares will in consequence grow even faster. A touching faith in company management. This is one of the most unlikely of the many myths surrounding the stock market. In fact a great deal of evidence points to the likelihood that high yielding shares are long term much better growth shares than growth shares and also better than the market in general.

Shares involve risk. They involve placing your money at risk where it might otherwise reside in a relatively risk free environment such as bank deposits or gilts. The only reason therefore to buy shares at all is in order to make a significantly better return than such risk free sources. With long term investing, buy and hold style, the dividend element is a crucial factor in boosting growth when reinvested. Any simple analysis of compound returns will demonstrate that adding say 4% per year worth of dividends over a long period will have a very substantial beneficial effect on the final sum created. Now that would be negated to some extent if it could be shown that in return for the relatively high yield of 4% you have to sacrifice something in the way of capital gain. But the paradox is that you do not. Contrary to the belief of some investors, and some investment writers who ought to know better, a well-selected group of high yield shares will, with reinvested dividends, be likely to outperform a selection of low yielding shares and also the market.

And yet how often have you read people saying that high yielding shares are thus because they are in trouble? I have seen this comment time and again over the years, usually aimed at beginners. Agreed some high yielders may be in difficulty, but as a generality I find this not to be true. It wouldn't surprise me if just as many, if not more, low yielding growth shares have eventually headed for disaster as high yielders. So the concept that high yield equals trouble is a complete oversimplification to the point where such advice is actually contrary to good investing practice. As so often in the market, to make good returns you have to step outside of what may be popular belief.

That's long term. But also for short term value share investing I have always liked the lure of the divi. Two main reasons.

Firstly it gives me an income while I am waiting for the share to do the business, an income which is quite probably much higher than I could get in the bank if I hang on to the shares for enough time. And if the share eventually doesn't do the business for me, then at least I've probably had a little compensation from the good yield meanwhile.

Secondly, yield is itself a value indicator. Higher yielders fall into the value camp though I am not claiming that yield alone makes a share a good value play, nor that low or nil yield shares cannot offer value because there have been many good examples of the latter, but it is one of the factors that for me makes a value share a value share.

Note also that is one of the most commonly quoted ratios with shares, along with P/E. Just about every paper that carries share prices will show the P/E and yield and similarly commentators on shares will usually quote these two criteria as a minimum when discussing particular shares as investments. This popularity of the ratio is important I find. Whether I like it or not, and I do, the fact is that a large number of investors and writers use the yield as one test of whether the share is appealing and not only value players but a large proportion of the investment population as a whole.

This means that by considering yield, I am using the same tool as many others and I find this important in value investing, whatever I believe to be the absolute merits of yield as a value tool. I am looking for shares that are undervalued on popular criteria, not on obscure criteria, so that the fact that it is undervalued is more likely to be noticed, and corrected.

For value to be more effective, you have to be playing the same game as all the other non-value players out there. It's just that you hold a better hand.