The Sweet Spot… Dividends are an important input to four of our portfolio formulas. Dividend payers can be divided into thirds. Those companies in the low and no dividend third have the expectation that allowing management to reinvest in the business will generate greater returns than paying a taxable dividend. In economics however there is always an “on the other hand.” The other hand is that giving management more resources will allow them to invest in their second best ideas. The result is lower returns. Most analysts’ projections for best future stock performers come from this third, which probably explains the analyst’s poor performance.

Those companies in the highest dividend payer group also have a following. Here the story is far from simple; shareholders like higher yields. Does this lead to fewer funds available for management to invest? Probably not. High dividend payers usually have Dividend Reinvestment Plans (DRIPs) for their shareholders. Thus they recover a substantial amount of the dividends paid out and can use the cash for additional investments. The objection is that DRIPs increase the number of shares in the company limiting the appreciation per share. In addition, high dividend payers also seem to use excessive financial management. They borrow short term and buy long term assets. The higher dividend is being paid out of this spread, an interest rate speculation. This is a violation of one of the basic rules of management, matching debt maturities to asset lives.

Those companies in the middle third of dividend payers have the fewest sponsors. Their story is not as easy to deliver and so cannot lead to a good marketing campaign. These are companies that generally compare the returns to shareholders of possible internal investments with the returns on dividends and share repurchases. The companies appear to choose the best options because a search of the actual historical data finds that this middle third is the sweet spot. Not only are the middle third dividend payers the top performing group but the same is true for most financial factors such as shareholder’s yield (dividends + buybacks) and free cash flow.

Why is this important to you? Our model requires that all investments pass a high hurdle in all criteria. Most researchers give each criterion a weighting and each security a score in that criterion. The highest total scores get placed in portfolios. The highest score in one criterion can offset a poor score in another. We want no poor scores. In other words, our portfolios are built from securities in the sweet spot of the market.

Sincerely,

Katz Family Financial