Sunday, July 29, 2007

Avoiding Dividend and Buyback Traps

Simply rushing to buy a stock because it has a high dividend yield or a company has announced a stock buyback will not guarantee an investor a nice total return. More often than not, a high dividend yielding stock is indicative of a company that has encountered a difficult operating environment. As the company's earnings prospects continue to languish, often times the company is forced to cut its dividend payment. Examples of this can be seen in company's like Pier 1 (PIR) and Kmart.

In an effort to avoid these types of companies, a recent article by The Motley Fool, highlighted three factors that should raise warning flags for an investor:
  • Erratic earnings: Companies with inconsistent or cyclical earnings have broken the hearts of dividend lovers many times over. When times are good, management teams at lumpy-earnings firms often fool themselves into believing the profits are here to stay, and they confidently raise their payouts accordingly.

    When the company's results revert back toward the mean, though, usually because cyclical firms often have little pricing power and their results are largely at the whim of uncontrollable market forces, management painfully discovers it has bitten off more than it can chew. Avoiding erratic earnings streams is step one for the dividend growth investor.

  • High or rising payout ratios: The same fat dividend that warms the heart of investors can sometimes give a company's management severe heartburn. Companies are loath to cut or suspend dividends even when that option, however ugly, is clearly the best move for the firm in the long haul. Managers know, with good reason, that dividend cuts and suspensions send the message that they do not think the firm will be able to maintain or continue growing earnings at a rate high enough to support their payout (emphasis added).

    It should be no surprise, then, that management is often willing to feign confidence by continuing to raise their payouts in the face of slowing or flat earnings growth...

  • Decelerating dividend growth rates: The last quick check also happens to be the first long-range sign that a long-growing company could fall flat on its face. Investors should take note when a company that has grown its dividend at a hearty clip over a multi-year period suddenly yanks back the reins and reduces the size of its dividend hikes.

    Now, there are plenty of reasons why such a move could make practical sense. The company could be shifting toward a policy of returning more money to investors through share repurchases, ramping up capital expenditures or research and development, or simply exhibiting prudent management.

Now what about stock buybacks. Generally, buybacks can be a positive indicator for a company's future prospects. However, as recently reported by Bloomberg:
While repurchases typically boost share prices, in the insurance industry, they're a sign that competition is pushing premiums low enough to threaten profit growth. Property and casualty stocks are lagging behind both life insurers and U.S. benchmarks as commercial insurance prices decline the most since they started falling in 2004.
The point is buybacks must be looked at from an industry perspective. As noted in the Bloomberg report:
The insurers buying stock wouldn't have to resort to repurchases if competitors weren't driving prices to potentially unprofitable levels, said Donald Light, an analyst at Celent LLC, a Boston-based financial research and consulting firm.

"Buybacks should limit price declines, but they're also a sign of falling prices,'' he said. "You don't think there's a lot of attractive new business when you're buying back your own shares."
When looking at dividends or buybacks, review past trends as well as historical industry practices before assuming all is well.

Avoid the Next Dividend Implosion
The Motley Fool
By: Joe Magyer
July 28, 2007

AIG, Chubb, Allstate Buybacks Portend Lower Premiums
By: Hugh Son and ZacharyR. Mider
July 27, 2007

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