Total Return Strategy vs. Income and Dividend Strategy for a Nestegg

[marko]

Let's say that a used car is being sold by sealed bids in a very efficient market (hundreds of buyers who can each find out whatever they want to know about the car). They can all see that there's a $50 bill in the ash tray of the car (the dividend). They write out their sealed bids to buy the car. Then, the owner of the car comes over and removes the $50 bill from the ashtray. What is the car worth to the buyers now? $50 less. So they amend their bids.

When a company is going to pay a dividend to present stockholders, the stock price reflects that soon-to-be-paid dividend. After the dividend is gone, the stock is worth less to potential buyers.

Ok. But if a company's board decided on a one-time 15% dividend one quarter (like mine once did; we just had a ton of extra cash and literally said "it's the stockholder's money, let's give some back").

The price dropped by that amount.

Buyers would see that the price of this good company was a bargain, create demand and within a few days the price would be back up--or even higher than before.

I know it's likely a bad example but that's what happened to us.

 

[ERD50]

Let's say that a used car is being sold by sealed bids in a very efficient market (hundreds of buyers who can each find out whatever they want to know about the car). They can all see that there's a $50 bill in the ash tray of the car (the dividend). They write out their sealed bids to buy the car. Then, the owner of the car comes over and removes the $50 bill from the ashtray. What is the car worth to the buyers now? $50 less. So they amend their bids.

When a company is going to pay a dividend to present stockholders, the stock price reflects that soon-to-be-paid dividend. After the dividend is gone, the stock is worth less to potential buyers.

Excellent.

Now throw in the 'noise' of the market - let's say they are also publishing real time updates for all to see:

"We just discovered the car will need a $1000 repair, that we will do for a flat $1000 fee". The offers drop by $1000 immediately.

"We decided to make the repairs, and we just completed them". The offers raise back up by $1000 immediately (maybe a bit more if a recent repair is seen as better than the old parts that might break down soon?).

My point is, there is so much noise in the market, other factors going on, that the offer price may vary by more than the dividend, so it isn't so easy to see. And we don't have a laboratory environment like my hypothetical identical companies, so you can't observe this precisely. But it just has to make sense that that dividend money doesn't just come out of nowhere - if they didn't pay it out, it would still be in the stock price. It can't exists in two places at once - that's fraud!

-ERD50

 

[ERD50]

Ok. But if a company's board decided on a one-time 15% dividend one quarter (like mine once did; we just had a ton of extra cash and literally said "it's the stockholder's money, let's give some back").

The price dropped by that amount.

Buyers would see that the price of this good company was a bargain, create demand and within a few days the price would be back up--or even higher than before.

I know it's likely a bad example but that's what happened to us.

And here's a link to a chart when MSFT issued an ~ 10% div (NOV 2004), they did not do well after that. Externals.

http://goo.gl/Km7kSv

But giving specific examples is missing the point. Look at the big picture, look at it logically. If I told you I added a bunch of insulation in my attic, but my heating bill went up the next season, do we determine that insulation is bad? No, because we understand the characteristics of heat loss. So we look at the other affects, seasonal changes, living pattern changes, furnace itself may be having issues.

Again, that dividend just cannot be 'magic money'. It comes out of the total value. Total return is all that matters, because total return is all money, not just some of it.

-ERD50

 

[mathjak107]

the bottom line is however many dollars in your investment you have at the ring of the bell is what is compounded on up or down over the new quarter ..

where the markets take it over the quarter will all act on the opening value of the investment .

if you had 10k the day before the dividend and reinvested the dividend then at the open you got the same 10k .

 

[mathjak107]

After my second cup, here is where I'm getting stuck maybe:

Dividends are paid from the profits a company makes (in general) or COH.

The NAV is set by the market on what a buyer and seller agree what is a fair price.

On Day One of a dividend payment I can rationalize a drop in NAV (maybe) but if NAV is set by the market the next day, I'm having trouble seeing the connection.

Maybe I'm just dense!

wrong , dividends are not based on profits at all . they are an amount the board agree's to part with in share value and give back to shareholders . .

company's still pay dividends even when they loss money .

many blue chips paid dividends right until the grave .

while markets set prices between buyers and sellers , the exchanges take all those offers and reduce's them automatically at the open by the amount of the dividend effectively lowering the stock price by the same amount .

that lowered adjusted value is where compounding by the markets starts off from .

 

[jim584672]

It is true standing orders are reduced pre-open on ex-dividend date. The price is determined by buyer and seller, not by an exchange. While the price generally trades lower on the ex date, it doesn't have to.

 

[clifp]

so the fact your investment may fall 40% but you get a dividend makes it ok ? ? not in my book

Ben Graham says that value of a stock is equal to the net present value of its future dividend payments.

So I look at my portfolio as a collection of future dividend payments. Now if I was in the accumulation phase, then I would be pretty indifferent if I got my 8% annual gain from 3% dividends and 5% stock price appreciation or no dividends and 8% stock price appreciation.

But I'm in the withdrawal phase and so I place a premium on the cash flows that I receive in the next year in the form of dividend payments, then cash flows that I'll get in future from Berkshire or Google when they finally start paying dividends. The lower volatility of dividend payments is quite valuable to me, because much of my expenses are fixed, and without a pension or SS, I need pretty reliable stream of income.

Obviously, I rather not have any investment fall 40%. But I have no control over what discount rate Mr. Market uses to value future dividend payment.

 

[samclem]

Ben Graham says that value of a stock is equal to the net present value of its future dividend payments.

And, of course, an assessment of the value of a stock using Mr Graham's methods might not match its price, because the price is set by buyers and sellers considering all kinds of things that may have nothing to do with the assessed NPV of future dividend payments.
We can know the price instantly and with certainty. I guess we can only know the true value retrospectively, once all the dividends have been received.

 

[clifp]

And, of course, an assessment of the value of a stock using Mr Graham's methods might not match its price, because the price is set by buyers and sellers considering all kinds of things that may have nothing to do with the assessed NPV of future dividend payments.

Yup. Price is what you pay, value is what you get. They seldom coincide.

If you are great at figuring out the difference between these two you become Warren Buffett. If you are merely decent you become like a fair number of folks on the board.

 

[mathjak107]

It is true standing orders are reduced pre-open on ex-dividend date. The price is determined by buyer and seller, not by an exchange. While the price generally trades lower on the ex date, it doesn't have to.

they are certainly reduced just by the fact the open is reduced and every order in house existing is reduced if higher automatically . that sets the opening prices .

that is always the starting gate . your starting value each quarter is that opening price after reduction . from that point on markets take over but what ever percentage they go up and down that quarter are on that opening value you have after the reduction .

if dividends are not reinvested you have less dollars working for you then the day before . there is no other way it can work . .

 

[Mulligan]

Yup. Price is what you pay, value is what you get. They seldom coincide.



If you are great at figuring out the difference between these two you become Warren Buffett. If you are merely decent you become like a fair number of folks on the board.

Im thinking like you do, Clifp, but with a different focus. Though I am just trying to achieve decent, safe returns. Exceeding has always been above my abilities. Value is what my focus is. When I can find issues that when issued were 150 basis points above 10 year treasury issue price, are now 400-500 basis above treasury with investment grade ratings, that is perceived value on my part. Of course this mind set is meant to beat the income market, not the total return or index market.


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[clifp]

Im thinking like you do, Clifp, but with a different focus. Though I am just trying to achieve decent, safe returns. Exceeding has always been above my abilities. Value is what my focus is. When I can find issues that when issued were 150 basis points above 10 year treasury issue price, are now 400-500 basis above treasury with investment grade ratings, that is perceived value on my part. Of course this mind set is meant to beat the income market, not the total return or index market.


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That makes a lot of sense. One of the hard things is figuring out absolute value vs relative value. Clearly on a relative basis those bonds or preferred issues are better deal than they use to be. But is that because they were way over priced when they were issued, or because they were fairly valued then and are undervalued now?

 

[Mulligan]

That makes a lot of sense. One of the hard things is figuring out absolute value vs relative value. Clearly on a relative basis those bonds or preferred issues are better deal than they use to be. But is that because they were way over priced when they were issued, or because they were fairly valued then and are undervalued now?

My perception has them at fair value when issued and "forced undervalue" now. It is all do to the uniqueness of preferreds when they achieve past call date... To put in comparison, a utility preferred with same investment grade rating but not having reached call date is yielding a tad under 5%. An exact rated utility issue I own a slug of is past call but yields 6.4%. In order for the issue to sell at true market rate its price would have to raise significantly above par to reflect this. However, only a fool would buy a past call preferred $4-$5 above par.
Now, they have been callable for decades and havent chose to do so, thus this is the reason it makes for an attractive risk for me. In these quirky situations, it isnt so much the value is hidden in that there is no way it can trade at its true market yield price.
So in theory, if rates rise these wont move much because they already had the yield protection to begin with and call risk would be minimized so in that scenario it would trade back to true market levels. Or at least historically that is how it has worked.


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[marko]

wrong , dividends are not based on profits at all . they are an amount the board agree's to part with in share value and give back to shareholders . .

company's still pay dividends even when they loss money .

many blue chips paid dividends right until the grave .

while markets set prices between buyers and sellers , the exchanges take all those offers and reduce's them automatically at the open by the amount of the dividend effectively lowering the stock price by the same amount .

that lowered adjusted value is where compounding by the markets starts off from .

mathjak,thanks for stickin' with me here! Sometimes I'm just a dumb*ss.

 

[mathjak107]

that is the beauty of these forums , we are all learning every day , self included .

 

[38Chevy454]

Given enough time all paths come out exactly equal - we're dead.

But is that point a crossover where some go up and some go down

 

[mathjak107]

Let's say that a used car is being sold by sealed bids in a very efficient market (hundreds of buyers who can each find out whatever they want to know about the car). They can all see that there's a $50 bill in the ash tray of the car (the dividend). They write out their sealed bids to buy the car. Then, the owner of the car comes over and removes the $50 bill from the ashtray. What is the car worth to the buyers now? $50 less. So they amend their bids.

When a company is going to pay a dividend to present stockholders, the stock price reflects that soon-to-be-paid dividend. After the dividend is gone, the stock is worth less to potential buyers.

i like that analogy .

 

[photoguy]

i like that analogy .

+1 It's a great analogy

 

[pb4uski]

.....Then if (taxes aside) it mostly doesn't matter either way I personally prefer to get a quarterly dividend payment. It gives me a sense of a paycheck that gets automatically deposited into my account.

I realize that it's "six of one..." but having a fairly predictable income works for me. ....

You can have predictable income (really cash flow) in other ways... I helped an elderly family friend set up an account at Wellington where dividends are reinvested but she has an automatic redemption each month that is transferred to her local bank account.... OTOH, we have a healthy cash component to our retirement investments in an online savings account and an automatic monthly transfer to our local bank account that we use to pay our bills... a couple different ways that total return investors create a predictable "paycheck".

 

[pb4uski]

i like that analogy .

+1

 

[Hamlet]

I think that the advantage of targeting dividend payers is that they are usually strong existing businesses where management is less likely to be destroying capital by trying to re-invest it in businesses they know nothing about, or in a core business that doesn't require any more capital.

Take McDonald's. They are a very good business, but there isn't going to be much growth going forward for them. Rather than have them try to buy other businesses that they might run badly or overpay for, or try to open restaurants that will cannibalize sales from their existing stores, I would much prefer that they pay dividends and buy back stock (assuming their share price is reasonable). That is part of my return from a great business that management can't destroy.

Much of what Corporate America does is destructive to capital. All of the dumb M&A, or trying to expand into non-core businesses, or the constant re-orging. A rising dividend over decades is a signal to me that the company has management in place that destroys less capital over time than the average group of nimrods in charge of companies in this country.

For the used car analogy-- I would bid somewhat less than $50 for the $50 bill in the car, because there is a decent chance someone will grab it and spend it on fancy mudflaps before they turn the car over to me after I buy it.

So while I invest for a total return, I certainly trust most of the businesses with a long history of increasing dividend payouts more than the average company.

 

[mathjak107]

what is interesting is dividends increased to the highest levels since 1998 with a record increase of 17.8 billion dollars in increased divends payed out just 1st quarter. the 2nd quarter may be even bigger.

all dow stocks pay divdends and 84% of the s&p 500 does too.

but according to a study done by howard silverblatt at s&p those dividends have been coming at a price as they go up and up..

a good part of that capital from free cash flow is gone forever and no longer available for compounding .

mid-caps and small caps who pay little in dividends have been far and away providing far better compounding and use of investor money for much greater returns..

in fact one of the least efficiant ways to grow investor money now is paying it out as a dividend.

as chuck akre said ,free cash flow in a company can be used to compound by buying back its own stock, investing in its own company or buying other companies . cash flow paid out as a dividends loses its compounding ability and much of it is gone forever and can no longer compound.

many of the great companies in the s&p 500 have lagged behind their non dividend payers in the midcap and small cap markets who now seem to be much more efficient at generating compounding on investor money.

midcaps and small caps have compounded the last few years 5-6% higher then their dividend paying cousins.

 

[samclem]

That is part of my return from a great business that management can't destroy.

You may be underestimating the power of inept management. The dividend check in hand is secure, all future ones depend on scores of things in and out of the control of company management.

Kodak, JC Penney, Citigroup, Barnes and Noble--all paid solid dividends for a long time.

 

[Mulligan]

You may be underestimating the power of inept management. The dividend check in hand is secure, all future ones depend on scores of things in and out of the control of company management.

Kodak, JC Penney, Citigroup, Barnes and Noble--all paid solid dividends for a long time.

One thing is sure.... Whenever management has to come out and say....."The dividend is secure", that is when I would start to get nervous.


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[Hamlet]

You may be underestimating the power of inept management. The dividend check in hand is secure, all future ones depend on scores of things in and out of the control of company management.

Kodak, JC Penney, Citigroup, Barnes and Noble--all paid solid dividends for a long time.

Sure, but at least two of those businesses were destroyed by technology changes more than inept management. Barnes and Noble and Kodak weren't destroyed primarily by mismanagement- they just made buggy whips.

Dividends are no guarantee, they are just an indication that management has some regard for shareholders, since paying a dividend makes the business somewhat smaller than it could be, and management is usually paid based more on the size of the business than its quality.