March 4, 2010

There are two economic reasons to own share: capital gains and dividends.  The beauty of dividends is that they reward you with a steady income while you wait for unpredictable capital gains.  According to Standard & Poors, when dividend payments were at their peak in 2007, they accounted for nearly 7% of US personal income.  As well, in the very long run, reinvested dividends make up a significant percentage of equities’ total return, with many studies showing it as more than 50%.  Those statistics emphasise how important a role dividends play.  Buy backs have a lot to be said for them too, of course.  They are distributions to shareholders alongside dividends, and offer tax advantages.  By using low-yielding cash to decrease the outstanding number of shares, the intrinsic worth of the company is spread over fewer shares, increasing the value of the remaining shares.  So in some senses, they are the best of both worlds; a short term return, but subject to capital gains tax, not the more penal income tax (note that, due to its collective status, the Strategic Value Fund has a different tax treatment than individuals).

Despite that, at Kennox Asset Management, we have a preference for dividends over buy backs in the mix of returning capital to shareholders, for two main reasons: dividends are harder to cut, and companies are notoriously bad at buying back their own shares.

Regarding being hard to cut, there is still a stigma attached to reducing dividends.  The announcement of a dividend cut is seen as a sign of weakness in the company’s prospects, as an indication that future cash flows will not be strong enough to continue paying dividends.  This is a sign of distress, so it comes as a last resort.  As the market focuses in the short term on the announcement of buy backs and not whether they are actually carried through, buy backs are much more easily shelved.  We’ve seen a recent example of this cycle.  In the US, dividend payments and buy backs both peaked in 2007, and since then dividends have been reduced by about 20% whereas buy backs have reduced by closer to 80%.

Regarding the timing of buy backs, companies suffer from the same psychological issue that affects other stock market investors – they tend to buy more when prices are high, and fewer when prices are low.  When profits are plentiful, the economy is going full bore and the company coffers are full, companies happily buy back their shares.  Almost inevitably this is when share prices are the highest.  Conversely, as the economy slows down, everyone gets nervous, share prices tumble, and, due to uncertainty and declining profitability, companies significantly reduce their buy back programs (incidentally, this is a time at which Kennox is likely to find shares attractive).  Companies fall prey to one of the most basic but insidious investment mistakes – that you pay a high price for a rosy outlook.

There are few companies that build up war chests in the good times and then have the confidence to use them to buy back their shares in the tough times when prices are most attractive.  They are few and far between – we would struggle to name more than one or two.

There is one last reason why we like dividends.  We have found dividend yields a useful valuation tool, helping us to identify companies that are undervalued.   Many high dividends will be cut, but we only need to identify the few that don’t cut.  A company on a high yield that is covered by sustainable profits is a very attractive investment.

It was not that long ago that paying dividends was being touted as an anachronism.  At Kennox, we firmly believe dividends have an essential role to play and should not be confined to history.

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The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

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