Monthly Commentaries

Dividends - Asymmetric Information – January, 2009

January was a poor month for markets across the globe with most major indexes falling between 5 and 7 percent. The period from September to January has been one of the most volatile on record and the gloomy economic news continues unabated. However, during this period of gloom and turbulence no less than 15 of our holdings increased their dividends. Clearly some corporations are capable of coping with the current economic environment, and are optimistic about their long-term prospects. Dividend increases should not be taken lightly and are a powerful signal of management's view of the future. Unless management is confident of a business's long-term prospects they would not commit to paying out cash. Based on the current news one could argue that conserving cash might be the way to go, but dividend increases speak to long-term prospects. This is a case of asymmetric information - management might know more about the business outlook than the market or investors. To quantify the impact of dividends on long-term returns consider that a full 2/3rds of long-term equity returns have come from dividends and dividend reinvestment. Look at this decade to date. Dividends paid to investors have added a full 10% to market returns since January 1, 2000 compared to simple price appreciation. Dividends may seem small, but over long periods they add up to a significant amount.

Dividends may seem quaint in this day and age. Any finance textbook demonstrates that an investor should be indifferent between receiving dividends and having a corporation buy back its own stock. Here is how this equivalency is supposed to work. Companies buy back stock thereby reducing the number of shares outstanding. As a direct result, earnings per share increase, and all else equal (meaning the p/e ratio remains the same), the price of the stock goes up and presto, there is your dividend. If an investor actually wants cash, then they just sell a portion of their holdings. But if the last few months have shown us anything it is that what is supposed to work in theory does not always work in practice. We have a couple of issues with this view of returning money to shareholders through stock buybacks. First, is one of control. An investor receiving dividends can choose what to do with the money; save it, reinvest in other companies or buy more of the corporations stock. But make no mistake about it- the control is in the hands of the investor. In contrast share buybacks are controlled by the corporation. They are not scheduled to occur on a quarterly basis and can be terminated at any time. In fact, most announced buybacks are never completed. Contrast the ease with which buybacks can be announced, delayed or terminated with cash dividends. To suspend a cash dividend is the last thing management will consider and can sometimes indicate a serious problem at the corporation.

Second, dividends impose a capital discipline on corporations. To maintain a dividend commitment a corporation must remain focused on cash generation. Moreover, it curtails the potential for cash to be put in marginal or risky ventures. Dividends represent a commitment to long-term shareholders. Finally, dividends encourage and reward long-term ownership. The concept of owning a company is all but lost on many investors. Indeed as the average mutual fund portfolio turnover reaches 120% per year (average holding time of 10 months) portfolio managers are just speculating on the price rather than buying solid businesses as a long-term investment. It is not surprising that turnover is one of the best predictors of performance - the higher the turnover, the lower the performance. Dividends are an important driver of investment performance and increasing dividends are a powerful signal about future prospects. Through your Toron portfolio you are an investor in businesses for the long term and not a speculator about where the next quarter's price will be. This discipline will help grow your portfolio over the long haul. Arthur Heinmaa, CFA Managing Partner