3 Signs You Should Buy That Dividend Stock

by JT McGee

Dividend investing has become really popular in the past few years.

There’s obvious reason for it: people want yield. You need only look to 2011’s hottest investments to find that investors are chasing yield in every way possible. (Spoiler: farmland and apartment buildings were some of 2011’s best performers.)

But when you should you buy a dividend-paying stock?

3 Times to Buy a Dividend Stock

In order of the worst reason to best reason, I’ve made a list of times when it makes sense to buy dividend-paying securities:

  1. Rates are high – Sounds counter-intuitive, right? Nope. See, the thing is, investors are happy with anything that yields more than 2% right now. Thus, they’re willing to pay way too much for a whole company simply because of the dividend cash flows. Dividend-paying equities tend to trade like bonds more so than equities that do not offer dividends to investors. The reason is simple: high-yields in low-yield environments push investors to bid up the price of dividend stocks. The best time to buy is when yield is not on every investor’s mind. Right now probably isn’t the time to buy the lot of listed dividend-paying companies.
  2. One-time dividend cuts – One-time dividend cuts are God’s gift to the patient investor. This year, I added Transocean (RIG) to my stock picks for the year. The company has liquidity issues, and faces large, one-off capital expenditures plus charges for oil spills and other problems. It even had to issue stock to raise capital. Suspending the dividend is completely logical in this scenario, yet dividend investors are leaving it. Investors who don’t chase dividends haven’t looked at it. When one core group leaves a particular stock, and another has yet to realize it, there is an obscene amount of opportunity. Does the stock have risks – yes, especially commodity price risks, which I don’t typically like. But the numbers work, and when the numbers work, you have to follow through with the plan.
  3. Complete restructuring – This is the best reason ever to buy a dividend stock. One example I have is American Capital Ltd. (ACAS). This company is a business development company, which means it buys smaller companies to resell, or makes aggressive debt investments in turnaround companies. Under the business development company and RIC structure, it is legally required to pay out 90% of its earnings in the form of dividends, much like real estate investment trusts have to do the same. However, ACAS changed its structure to a corporation in order to work through net operating losses. To put it simply, the firm lost its shirt in the economic downturn. By switching back to a corporate structure, it can use those net operating losses for a tax benefit, essentially giving it cheaper capital costs. Dividend investors left it because it would suspend its dividend. Europe woes scared investors out of it. John Paulson (a hedge fund manager) had to sell a lot of it. And I was there to love on it, and tweet to my brother from another mother about it.

     
    Here’s the thing; the company has holdings worth ~$12-14 for every share, which currently trades for $8.54. Analysts ripped corporate officers to shreds on the fall 2011 conference call, railing on the management for not buying back stock. Hello! If you can buy $14 worth of portfolio for (then) about $6.50 per share, why wouldn’t you do it? Of course, financial reporters make it out to be some grand conspiracy when in reality is was the idea of the analysts to reinvest cash flows into buying back stock rather than paying dividends. (Honestly, had this guy bothered to actually listen to the conference call, he would have noticed the onslaught of share repurchase questions. In fact, it was so heavily tilted towards repurchases that an analyst watching the company’s debt issues noted that the debt investors matter too. In other words, keep some cash on hand to have liquidity – don’t buy back stock with zero regard for the balance sheet.) Will the company pay dividends in the future? Absolutely! It will as soon as the market value of the equity is equal to the value of the underlying portfolio. Management is keen on going back to the BDC + RIC structure in the future (probably 2013). Ultimately, this company cannot maximize shareholder value until it goes back to a business development company structure. We just have to wait for that to happen. No sweat. I can wait. If it pays out a $1.20+ annual dividend by then, a yield of 9% would give it a value of $13.20+ per share. Yeah buddy!

But I thought you don’t like dividends!

Fair enough, I don’t like dividends. I do enjoy buying companies at a discount, however, and when you can buy a troubled dividend-paying equity sold off by a large block of investors you can find incredible opportunities.

Some investors only want to hold dividend-paying stocks by choice. Others have an obligation to provide yield to fund investors and have to follow a strict prospectus. Still many more see any dividend cut as the future death of a firm, even if it is often in the company’s best interest.

Markets are not completely efficient. It’s true. I can say this until my face turns blue. In the short-term, prices for public companies are not based on the value of the firm, but on the supply and demand for shares in the firm.

I may not like dividends, but if it takes the loss of a dividend to create value, and the resurgence of a future dividend to boost the price per share, then I can be a dividend’s best friend. I won’t sit around and wait for the few pennies per share, but I will gladly stick my capital in as a placeholder for the people who do. And that, I find, tends to be a much better investment.

Photo: volpelino

Disclosure: Long ACAS equity, and RIG calls.

{ 2 comments… read them below or add one }

PK March 8, 2012 at 00:56

You know I like both RIG and ACAS (since I told you, and also that I invested in their cousins ARCC and HP) and I think you’ve got some good firms there… but on dividends…

I’m of the opinion it doesn’t matter where your profit comes from. Mind my wording – I care about profit after taxes. My biggest concern with dividends is that they will soon be less valuable from a tax perspective than capital gains. Tax the rich people collecting dividends? Be prepared for dividend cuts, or at least less dividend raises… it is the investor class!

But yeah, I see no reason to specifically seek out dividends. You should care most about fundamentals, whether that’s assets, cash flow, or some other tangible number in a quarterly report. Whether your gains come from capital gains or dividends matters not – although capital gains are easier to time. In a vacuum, I’d prefer a company with less dividends than one with more.

Reply

JP@Novel Investor March 9, 2012 at 14:15

Owning stock just for the sake of dividends never made sense to me. I need to see some underlying fundamentals that show growth and future stock value appreciation. If the company happens to pay a dividend in the process great. There’s nothing wrong with getting paid to wait.

Reply

Leave a Comment

*

Previous post:

Next post: