Smart Investing


January 13, 2012


Don't buy based on dividends

I’m beginning to hear more talk about dividends, which is a good sign that the economy is doing better and investors have an interest in investing. But be warned: Do not buy a stock just for the dividend. I’ve said it before, and I think it’s time to discuss this.

In 2011, all the stocks combined in the S&P 500 paid out in dividends $240.6 billion — nearly a $36 billion increase from 2010. The record payout in dividends was $247.8 billion in 2008. Based on data released from the S&P, dividends are estimated to be $252 billion in 2012, which will be an all-time record for S&P 500 companies.

I read one article discussing McDonald's and how, since 1976, it has increased its annual payout to shareholders every year. McDonald's just increased its dividend by 15 percent to 70 cents, up from 61 cents. With McDonald's trading around $100, that puts the yield at 2.8 percent. I’m sure after reading about that some went out and bought McDonald's stock under the impression that it was a great deal.

Currently, McDonald’s trades around 18 times forward earnings. Generally at 20 times forward earnings I sell, and when buying I refuse to pay more than 15 times forward earnings. You may hear then the payout ratio of McDonald's is 47 percent, which is pretty good, but the time to buy this stock was five years ago, when it traded around $45. Even better was January 2003, when the stock was at 10-year lows of $14 to $15 per share.

I remember looking at the stock. McDonald's was then getting all kinds of bad press surrounding topics ranging from dirty bathrooms to how bad the food was. But at that time the fundamentals looked good, and that was the best time to buy the stock, when no one wanted it. Not today, when McDonald's is receiving mostly praise.

I don’t think it is a terrible buy at this level. A target price using a multiple of 20 with the mean estimate of 27 analysts at $5.73 for the year ending December 2012 is about a $115 per share, roughly a 17-18 percent gain from here including the dividend. But it is no bargain at current levels, and could hang in this range for years to come.

I’ve written often about the complaints that some stocks have gone nowhere in the past 10 years because investors overpaid for the growth.

Investors who bought McDonald's back in January 1999 at $45 saw no gain on their stock until after January 2007. Come January 2003, investors who held on experienced a 68 percent loss over the past four years. I’m sure many sold the stock at losses rather than looking at the fundamentals and determining McDonald's could turn it around.

Another area of caution for investing in McDonald's would be its high debt to equity, currently at 94 percent, which is above the industry average of 84 percent. It’s not a problem yet, but it could be down the road. And if interest rates rise, which I think they will, the company could see increased costs on servicing that debt.

Companies can also cut their dividends as well as increase them, and 101 American companies decreased their dividends in 2011. I’ve seen some companies drop all the way down to a penny per share per quarter, so in the future they can say they have paid dividends constantly for the past 100 years or whatever it may be.

A couple years ago, we saw banks reduce or stop paying their dividends. Going forward in 2012, I think we could see many banks increase their dividends, and with the stock prices on banks still pretty low, the yields should be good. If you buy now, when the bank increases its dividend payout, in years to come your yield will be very attractive because you invested when the banks were out of favor.

When building your portfolio, it’s OK to have companies that don’t pay dividends because they are reinvesting their money back into their business, which should grow the business more down the road. If you have a well-balanced portfolio you can still get a 2 percent yield or so off the dividends and still see some good growth. Don’t just look at the yield, be sure the fundamentals look attractive as well.

Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.


January 13, 2012