10/5/10 Dividends & P/E

10/5/10 Dividends & P/E

As our previous writings indicated, we key on a few metrics that are meaningful to us. We screen stocks on high dividend yield and low P/E (stock price divided by earnings). This has been our primary screening criteria or way of identifying the stocks we want to look at versus all the other stocks. Once we get a list of stocks, we look to see if there are traded options on the stocks. If they have a good options profile we then dig deeper into their financials.

There are endless writings on the value of our two initial screening criteria, dividend yield and P/E. We like dividends so there is not much to write about here. Dividends reflect net earnings that the company cannot justify keeping. Paying dividends in addictive and if stopped, management gets fired unless they can provide a really good explanation. The cash used to pay dividends is generated from companies with any combination of 1) profit margins that are a) excessively high, b) ok or c) poor and 2) expense margins that are a) low, b) ok or c) poor. Management needs to be willing to cast off excessive cash to make investors happy and take over firms mad, tight-fisted or awful. The skill in delivering a dividend is with management’s ability to manage the card it is dealt and pay out money. Pretty simple stuff isn’t it?

The P/E ratio is another matter and we forgo all the superfluous discussions. Again, for us this is another simple measure, except it can be tortured into millions of different arguments. Too bad the minutia gets into a simple equation. P/E is the only readily available indicator that pits investors to management. Let us break it down.

The price of a stock reflects investor sentiment of value. Current or future value is of little matter because the price reflects what someone is willing to pay today for the privilege to own the stock versus what someone else is willing to some sucker who wants to buy it. Supply and Demand anyone? If more people want to own the stock – more buyers than sellers – the price of the stock goes up. If more people want to sell the stock than buy it – more sellers than buyers – the price of the stock goes down. Therefore, the current price of the stock reflects investor’s view of the stock price. We can leave the present value of cash flows, dividend discount model, etc, etc, etc on the shelf. Supply and Demand rule the price of a stock.

We all know that earnings are manipulated numbers. Management does their best to “own” this number. Why do we own stocks as investments in the first place? Because deep down we like the management. Investors get lots of mail from the companies whose stock they own. Vote for this, vote for that, we are doing this, we are doing that – all for you! Gobbledy gook filled mail all written by lawyers telling you how lucky you are that the company is being run by such fine upstanding individuals who want to make you rich for owning their company’s stock. Oddly enough, there is a lot of truth in their statements. If the investors are happy management should get to keep their jobs and get rewards. Ever wonder why the likes of Ted Kozlowski of Tyco, Maurice ‘Hank” Greenberg of AIG, Warren Buffett of Berkshire Hathaway or Alan Greenspan of the Federal Reserve, kept their jobs for so long? Need I say any more? Of course I will - Investors buy stocks because we like management. If we do not like management, we do not buy the stock. After all, how many times have you heard anyone say, “I’m buying this stock because management is awful and ruining the company”? If earnings are managed, so be it, just do not let them disappoint.

Therefore, we see the P/R ration as an indicator of the struggle between investors desire to own stock in a company and managements desire to 1) keep their jobs and high pay and 2) attract ownership interest. This being said the natural result is low P/E companies have management that cannot convince investors to buy more stock and managers of high P/E companies have more than convinced investors to buy their stock.

In conclusion, with all this having been written, there are exceptions and not every participant in the markets are investors. Take over companies like poor management, growth investors like rollercoaster rides and do not care and finally speculators like stories and rumors. We just try to keep it simple and real.