As of this writing the Dow Jones Industrials average is 27% below its October 8, 2007 close of 14,093 and about 8% below its April 19, 2010 close of 11,204. The yield on the Dow stands at 2.7%. It used to be that a dividend yield below 3% signaled an oncoming bear market. The yield has not been that high since the fourth quarter of 1990, almost twenty years.
At Marc J. Lane Investment Management, Inc., one of the factors we look for in choosing stocks for our portfolios is the ability to pay a steadily rising dividend regardless of the actual yield. Eight years ago in this column I examined the issue of how companies allocate capital and it is worthwhile to examine it again.
The question at the heart of the matter is: Are shareholders better off when companies reinvest all their profits in their businesses as opposed to paying a portion out to them as dividends? The answer still is compelling that a dollar paid out as dividends benefits the investor a good deal more than if it were reinvested in the company. This sounds counterintuitive. As the argument goes, earnings that are reinvested and shares that are repurchased should lead to higher share prices on which an investor may then defer the tax until the shares are sold, and then pay lower capital gains tax rates, instead of ordinary income tax rates.
The study published by Robert Arnott and Peter Bernstein took issue with this seeming logic. Their study focused on earnings reinvested in the business, rather than paid out as dividends. They found that when the payout ratio of earnings as dividends climbed above 50% in the late 1950s, subsequent inflation-adjusted earnings growth was between 2% and 4% per year. When the payout ratio fell below 50% in the late 1970s, subsequent real earnings growth was negative. In a 2003 study by Robert Arnott and Clifford S. Asness titled "Surprise! Higher Dividends = Higher Earnings Growth?" the authors found that companies with higher payout ratios actually had higher earnings growth over the subsequent ten year period. This was true in every rolling ten year period from 1946 to 1991.
The authors did acknowledge that it is possible to have high earnings growth without paying dividends. Companies that had earnings growth in excess of 20% typically did not pay dividends since they needed this capital to sustain their growth. However, growth of this magnitude is infrequent and not sustainable over the long term. Furthermore, in a 2006 study, these results were replicated in several developed markets in Canada, Europe, and Asia. The results were consistent with the Arnott and Asness study. We believe these studies provide excellent evidence for our strategy of seeking companies that have the ability to pay a steadily rising dividend.
One example of a company in our portfolio that has always shown strong capital discipline is Pepsico. Founded in 1898 and incorporated in 1919, Pepsico is a global leader in carbonated and non-carbonated beverages and salty snack foods. The company also is increasingly focused on expanding its line of healthier beverages and foods. Indra Nooyi has been the chief executive since 2006. The management team is very innovative in their efforts to continue their past successes. The line of healthier products including Aquafina water, Tropicana and Naked Juice, and Quaker oatmeal and granola bars is growing faster than carbonated beverages and salty snacks. New snack foods contain more fiber and whole grains.
Earnings in 2010 will increase 10% over 2009 and we project 15% growth in 2011. Pepsico's dividend yield is 3.0% and the recent 6.6% raise is the 38th consecutive annual increase. At 15.5 times 2010 earnings, Pepsico is a solid bargain for the coming year and the shares should outperform the market for the next several years as the company introduces new products and gains market share overseas. Pepsico recently purchased its two largest bottlers which will enable the company to reduce cost overlaps significantly. Finally, return on shareholder equity has consistently been in excess of 30% for the past decade. Boring can in fact be quite beautiful.
Kenneth N. Green is Senior Vice President and Director of Investment Research for Marc J. Lane & Company and Marc J. Lane Investment Management, Inc. Mr. Green is a graduate of the University of Michigan (M.B.A.) and the University of Illinois at Urbana (B.S.). Mr. Green is also a Certified Public Accountant (CPA).
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