December 10, 2008

Buy with a solid Dividend (Session 7)


The final page in our series on Graham's investment theory is dedicated to dividends. I saved the best, and most contentious for last. Investors love to split themselves into groups- technical analysts, fundamental analysts, value investors, growth investors. In the same vein there are dividend investors and growth investors. Without further adieu let's get into it.

What is it?

At the end of every financial quarter a well run business will have funds left in its budget. The business can choose to invest that money into the business in order to hopefully make more money in subsequent periods- buy machinery, pay off debt, buy another smaller business, open another store etc. Or the business can give the excess money and give it back to its investors as a reward for investing in the business- this is a dividend. Dividends can be paid on any schedule, quarterly, yearly or any combination of the above.

What does it tell us?

A company chooses a direction when it decides to pay a dividend. They have decided to be a type of a business, the type of business that traditionally has somewhat slower growth because it is returning the investment to the shareholder. These businesses get a pass on lacking big bang growth- but it comes at a cost. The business must be consistent about the dividend. Buying a company that pays a dividend for one quarter then cancels it for a year and then reinstates it again is giving mixed messages on what type of business it is.

A dividend is like a snooze button for a long term investor. If I buy a stock I expect returns. If the stock is consistently going up I can see those returns as I know I can sell that stock off in an instant for a healthy reward. But what if it does nothing or even goes down- then what? Well then I either have to liquidate and take my loses or grit my teeth and hope for a return to profitability on my position.

Here is an alternative story for you though. Imagine my stock goes down or stays the same could I entice you to be more patient with the stock if I give you 3% of your money back now and make you believe I will give you a further 3% back in another few months? Graham liked dividend stocks, they rewarded this type of patience. We have talked all the way through this series about different measures of Graham's theory being used as insurance techniques- this is the biggest of them all: even if I am wrong about the potential of a selected company I know I can receive a return from my investment so long as the company continues its dividend.

Incidentally dividends also have another interesting feature about them- they cause more consistency in the price of a stock. Every time a dividend period is coming close no one wants to sell their stock as they know it won't be long until a free payday arrives. Even if there is bad news in this period more people will hold the stock and think about the move instead of the knee jerk reaction that traditionally happens in the market.

What does Graham use?

Graham liked dividend paying stocks as we mentioned above consistency is important. If the company has a long track record of having paid a dividend then there is a very good chance it will continue to do so in the future. Graham liked a company with an:
"Uninterrupted payments for at least the past 20 years."
P. 348 The Intelligent Investor
While this is challenging to find the sentiment is clear- if they are consistent about the dividend they will probably be consistent in the future.

"the defensive investor should be able to count on the current 3.5%"
P.25 The Intelligent Investor
Graham also looked at stock investments as an alternative to bond investments. So if a stock investment can't beat a comparable low risk bond's rate of return why would I buy the stock? To put it another way, if you could get 5% in a savings account why on earth would you risk the money in the market unless you knew you could be fairly sure you could beat that 5%.

Hope you have enjoyed the series on Graham investing please vote on the poll to the right to guide what series we will look at next and please be sure to see the other parts of this series if you missed any:

Intro
Buy on the Cheap: Price/ Earnings
Buy a Company with a Future: Book Value
Buy on the Cheap: Price/ Book Ratio
Buy a Company with a Future: Current Ratio
Buy a Company with a Future: Based on its Past