Covington Investment Advisors, Inc. Blog

News, Tips, Commentary, etc.

Paying Dividends

 

All investing, when distilled down to its core, is outlaying cash in the present, to receive more cash in the future. In the world of equity investing this is most apparent in dividend stocks where you pay an initial price for shares (cash outflow) and then receive intermittent dividend payments while you own the stock (cash inflow), and if desired can sell the stock in the future (cash inflow). These dividends are typically paid out from the cash left over after a business runs its operations and (ideally) has profit left over. From an investors perspective dividend payments can be reinvested back into shares of the same or different company which will produce even more dividends, and so on and so forth. This is what contributes to the compounding effect of stocks and why over long periods of time make great investment vehicles. The broader equity market has struggled this year amid a challenging economic landscape but still S&P 500 companies paid out a record $140.6 billion in dividends in the most recent quarter. Dividend growth in the coming years will likely be more muted but still positive.

Of course not all stocks pay dividends and some companies instead use their profits (or future profits) for internal uses such as paying down debt, making an acquisition, buying back shares, etc. In the real world companies are unique and do a combination of these depending on several circumstances. Stock buybacks in particular have become a contentious topic but for the sake of this note think of them similar to dividends where the company is giving cash back to shareholders. Savvy companies use stock buybacks to their advantage in periods of market turmoil as they can earn a return on investment in their own shares by retiring them before the market cap increases, which is then concentrated in fewer shares. The poster child for this strategy is Apple which enacted large share buybacks with their excess cash beginning in 2013 when the stock price was depressed. This action was not appreciated by investors at the time but contributed to the strong performance of Apple shares since. Many of the companies in your portfolio are doing that same thing right now as markets have sold off in the first half of the year. Their strong balance sheets and large cash reserves that we constantly belabor afford them the luxury of buying more of their shares for less capital.

The chart above shows the broad hierarchy management teams go through when choosing to allocate capital for shareholders. An example of a company that has taken the value creation path in the bottom left of the chart above is Berkshire Hathaway, the conglomerate built by Warren Buffett. Berkshire Hathaway has never paid a dividend but instead retained and allocated its capital to acquisitions (Coca Cola, Apple, BNSF, Dairy Queen, etc.). If executed properly this strategy can be lucrative, but does come with perils as making a haphazard acquisition can severely handicap a business (think of AOL buying Time Warner in 2001). This is why we prefer companies with experienced management and biased to paying dividends as opposed to being overly acquisitive.

But our preference for dividend-paying companies goes beyond just the capital allocation framework. Dividend paying companies by their nature have entered the mature, stable part of their life cycle. They have already built their competitive niche, invested in organic growth, reinforced financial flexibility, and are now returning cash to shareholders who can use those funds for personal use or to reinvest. Using the chart above they have begun to move down into the bottom right corner of ‘value distribution’. This places them in the “proven enterprise” category we harp on.

What's more is that we scrutinize this dividend bias even further and own companies that have already solidified themselves through the left hand of the chart so they can continue to grow dividends through periods of economic stress. Stock prices are directed by the market but dividends are dictated by business fundamentals and execution. Having a track record of strong management and capital allocation as previously described in this note has shown over long periods of time to be the best approach to growing and protecting capital.

This is a busy earnings week in the markets and so far results have been stronger than expected. Still, as we progress through this challenging landscape we wanted to illustrate how the companies in your portfolio are using this opportunity to grow shareholder value for the long-term and why staying invested pays dividends.

 

Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.

Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.

 

Taking the Temperature of the Market

Most Recent Blog Posts

Connect With Us

 

Covington Investment Advisors, Inc.
301 E. Main Street
Ligonier, PA 15658
Phone: 724-238-0151
Fax: 724-238-0148
Email: covington@covingtoninvestment.com