Are Dividends Irrelevant, Or Even Harmful? (Part II)

Some say that paying a dividend is neutral to negative, since it removes potential opportunity from a company in the event that a suitable growth opportunity appears that requires cash in addition to taxation issues (See Why Dividend Paying Stocks Are a Mistake as one example). Thus, future earnings growth could be limited. The counter argument follows this line of reasoning as discussed in Part One:

• Dividend stocks are more closely linked to the price to earnings ratio as dividend yield is essentially a function of the P/E ratio with the inclusion of payout ratio. In fact, the lower the P/E ratio, the better this is for the dividend yield – provided the company does not have sliding fundamentals.
• Dividends lowers the P/E ratio in the opposite way buybacks do (buybacks try to boost EPS for better ratios instead of lowering price with same EPS). The removal of equity from the company lowers the share price in equal proportions. Provided the removal of equity does not impair the current earnings (but not earnings growth exactly), the price to earnings ratio is reduced. This will either give an immediate increase to future dividend yields, allow the company to lower payout ratios for dividend stability, or it will boost share prices.

Dividends are similar to buybacks. Buybacks increases EPS to boost the P/E ratio. Dividends lowers the price while maintaining the EPS to boost the P/E ratio. The net effect should be the same, except dividends are taxed differently than capital gains and dividends discourage buyback price manipulation for executive or company option policies (see part one for an explanation of this).

In addition to improving certain fundamental ratios and creating earnings-based value in share prices, there is a second reason why dividend investors may choose to purchase income producing stocks, and it has to do with anchor points. What are anchor points and how might they affect dividend stocks?

Anchor Points

Anchor points are thresholds in the minds of investors that may not have true significance on paper beyond the psychological value. This may occur when stocks find support at whole dollar amounts or rounded off numbers. If you look at a historic chart of Google since going public, you might notice major support and resistance every $100 level. If you zoomed in to more recent price action, you could see other zones every $25. Are the 25 and 100 dollar values significant in some way? Probably not-- but it has psychological merit in the minds of investors. (Chart below is the last 3 years of Google (GOOG) and you may notice some major turning points in the $100 zones with smaller pullbacks at $25 multiples).

Click to enlarge

Other major anchor points are 52 week highs and lows. Prices meet with support and resistance at these levels, but often show excess or sped up gains or losses once these thresholds are punctured. Are the 52 week highs and lows truly meaningful numbers? While they are visual thresholds on a price chart, you might otherwise have a hard time finding a cause for the 52 week high and low effect by solely looking to fundamentals.

Dividends can also provide investors with an anchor point. How so?

Dividend Anchor Points – How Low Can You Go?

Dividend stocks attract dividend investors with income mindsets. Anchor points should resemble some of the commonly held beliefs and viewpoints of the buyers which may not have significance otherwise. How might dividends create anchor points? Consider Sunoco Logistics Partners L.P. (SXL).

Click to enlarge

SXL is a limited partnership and differs from your typical dividend stock. Technically it pays cash-flows and the tax implications are different – but there are enough similarities that many dividend investors will invest in these equally.

For the past 5 years, the earnings and dividends have increased annually (not including trailing 12 months). Between 2004 and 2006 the average dividend yield hovered around 6%. This then became an anchor point to investors and any divergence could have an elastic band effect. In 2008 the share price hovered around the $15 - $16 range, while total dividends were $1.26 for that year ($1.16 the previous). This would create a high yield of over 8%. Provided earnings didn’t take a huge dump downwards, might investors who were used to the 6% yield push prices up once macro-environment risk was off the table? It seems that this did create an elastic band effect, where prices shot up as yields dropped back down to the 6% range in 2010. With price momentum the yield is now pushed back down to 4.5%.

Of course, the anchoring effect can work both ways as earnings may need to play catch-up for a while as the price ascent slows. Unless momentum trading continues strong or earnings accelerate faster than price, the fair value based on anchor points alone currently sits at $27.50. Of course, this is only one factor to consider and it sometimes takes years to swing.

Some Anchoring Factors to Consider

When considering the investing value of anchor points, look for companies with stable earnings or ones that are growing. The last thing you want to do is to chase a stock that is dropping from sliding fundamentals and the spiking yield will quickly settle lower – not from a share price jump – but from diving earnings.

Another consideration is that an anchoring point may change over time. If interest rates are high, the anchoring point could be at a much higher yield. If interest rates are low, investors might lower an 8% yield anchoring point down to 5%. Thus, you are not simply running out to buy 4% yields in all conditions. You also need to consider historic yield averages, current risk-free rates, earnings stability and growth and dividend stability and growth.

So while some view dividends as a poor way to return cash to the shareholder, others view it as a less manipulative way to return earnings, a method to lower the price to earnings ratio which should either increase yields or support prices, and to create an anchoring point which should further support prices in a down market or create ballast when macro-conditions improve.

That being said, these are only my personal viewpoints and I do entertain opposing stances when logical arguments are made. In other words, whether you agree with me or not, feel free to reply in the comments section below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.