A Great Dividend Is Not Enough

 | Nov 06, 2012 | 1:30 PM EST  | Comments
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Over the past weekend, I saw and read more articles about dividend stocks than I can recall. The cover of Barron's last week promoted the "Best 25 Dividend Funds." The Wall Street Journal wanted to know if dividend stocks were a bubble. And every publication in between is now touting the value of dividend-paying stocks. Google "dividend stocks," and one is immediately bombarded with a litany of bullish takes on the value of dividends.

To be sure, history has confirmed that dividends deliver enormous value over the long run. Companies that have a long history of dividend payments often increase the dividend on a regular basis, and that creates exponential returns for long-term investors.

For example, if you bought Johnson & Johnson (JNJ) in 1996 at its high price of around $27, you would have gotten an annual dividend of $0.37 a share, or a dividend yield of 1.4%. Fast forward to today, and Johnson & Johnson is paying shareholders $2.44 a share. The relatively few Johnson & Johnson employees and legacy investors who have owned shares for decades are capturing a yield alone of nearly 10% a year. But more importantly, JNJ shares now trade at $70.

Therein lies what I call the dividend dilemma: Dividends are clearly valuable and create enormous value over time. Yet investors should be careful when reading most of the articles that promote investing in dividend-paying stocks. Very often, the entire discussion is centered on the actual dividend. Investors should never invest solely on the basis of a dividend. An investment should be made on the basis of earnings and cash-flow growth.

Johnson & Johnson's amazing divided story exists only in the context that in 1996, it had earnings per share of $1.09. In 2011, EPS was $5.00. Without that earnings growth, you wouldn't have the dividend story we have today, nor would you have the solid share-price appreciation. Earnings and cash-flow growth create the value of dividends over time.

So don't invest in the dividend, invest in the earnings and cash-flow growth. The maritime bulk shipping industry is a recent case in point. Dry bulk shippers were market favorites in 2006 and 2007, when they sported dividends in the high single digits or higher. Yet not only does Eagle Bulk Shipping (EGLE) trade at fraction of its share price in 2006, the once-juicy 9%-10% yield has vanished and is likely never to appear again. Even Star Bulk Carriers (SBLK), which still maintains an attractive dividend, has seen its shares dwindle by more than 90%. So much for dividend value.

Warren Buffett was recently asked why he isn't investing in names such as Verizon (VZ) and AT&T (T), given their 4%-5% yields and their current operating strength, thanks to the surge in smartphone and tablet use. Buffett remarked that he can't forecast what those businesses look like in five years. It a typical Buffett answer, and if he had made that comment five years ago, he would have clearly missed the boat. But Buffett's insightful observation was that he cares about cash flows first and foremost, not the dividend. You cannot have dividends without cash flows, and intrinsic value per share doesn't increase with positive returns on invested capital.

Understand the dividend dilemma as you navigate the endless optimism about dividend stocks today. 

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