The Ultimate Dividend

Much is talked about dividend investing. But few know of one particularly type of dividend that I think is very powerful if employed appropriately and honestly (that is, if it's not abused by unscrupulous managers): stock dividend.

Why?

Because stock dividend:

1. Lets the investor control how much in taxes he/she wants pay.
2. Lets the investor decide whether to reinvest in the company or cash out and buy another investment.
3. Is tax free.

Here's how it works. Suppose company A has X in earnings. It can choose to issue a fraction of X as dividends and retain the rest. If dividends are paid, say Y% of X, investors face an automatic dividend tax hit and then need to make a decision whether to buy something else, reinvest the proceeds in the company or let it sit somewhere, such as in a money market account.

But company A could elect to issue a stock dividend instead, in the same amount as before (Y%). The stock price should go down proportionally, like what happens when companies pay out a cash dividend. But then the investor has extra shares, that make up the same total he had before. The only difference is that he now has a few extra shares, which he can keep or sell for cash as before -- the difference is having the choice.

If stock dividend is more flexible than cash dividends but otherwise equal, why don't companies choose to do it all the time?

I think it has to do with the fact that many investors don't understand it well and also due to the danger of companies being perceived as being in a weak financial situation.

As it happens, companies typically issue stock dividends when they need to conserve cash. Two recent examples are Sunstone Hotels (SHO) and Lloyds Bank (LYG). Sunstone not only paid out in stock, but it raised its dividend -- using money that it did not have. Its payout ratio is a whopping 216%. So, in this case, the stock dividend is nothing more than a stock split. It does nothing for the shareholders.

Similarly, Lloyds paid out 339% of its "earnings" in stock, also using money it did not have.

These are examples of when not to pay a dividend -- in cash or stock.

Now, going back to why stock dividends are useful if employed properly by honest companies.

Let's go back to our company A above. It has X in retained earnings, it could issue 2X or 3X (or any number) in shares and declare as large a "dividend" as it wants, like SHO and LYG. But let's say they're responsible folks and won't pay out more than say 0.5X. If the company pays out cash, the share price is automatically reduced by 0.5X divided by the number of outstanding shares -- to reflect that X dollars are now no longer part of the company's assets.

On the other hand, if company A chooses to pay out in stock, the share price will also decrease by an amount proportional to the new shares issues, which is exactly 0.5X divided by the share count. But now investors have 0.5X in extra stock certificates. They can elect to maintain their claim on the entire share they had, or sell the extra shares for income, just as if the company had paid out in cash. Either way, the result is the same.

Here's an illustration:



With stock dividends, the default behavior is to reinvest the money in the company (without incurring transaction costs nor taxes) while in the cash dividend case, the investor had no such choice -- he had to pay taxes and then take an action to deploy his new cash.

I think all companies should consider using stock dividends more often. All else being the same, investors should be given more control over their tax and reinvestment situations.

However, to avoid the situation where share counts increase but no cash ever exchanges hands, I'd like to see a hybrid approach: companies should pay out a quarterly cash dividend, and yearly they should issue a special stock dividend with the unpaid part of their earnings -- like they do with bonuses for their employees. This special stock dividend would fluctuate in value over time, to reflect the company's ups and downs as it goes through good and bad times.

Desperate Credit Card Companies Pulling New Tricks

It's amazing how sneaky credit card companies are and have been. It doesn't even surprise me much anymore. But they do manage to catch us off-guard every now and then and create new headaches all the time.

People who don't check their statements carefully might be paying extra fees for everything without knowing.

The newest trick on their book is the following: if a company has headquarters in another country, but conducts business in the US as usual, they now apply their special foreign transaction fee even on transactions generated in the US and in US dollars.

That's just insane.

I just got a bill today with a three percent surcharge because the company that billed me, called "British Airways, USA", located in Florida, US, is an arm of UK-based British Airways. The charge was originally in USD and still the three percent fee applied.

(BTW: I called British Air and a representative told me there are lots of complaints like mine, and that the card was charged in the US, in US dollars, by their american subsidiary, and that we should not pay these abusive fees)

Of course, I'm disputing the charge with the credit card company. But it goes to show how sneaky these people are.

This, of course, wasn't the first time I had to dispute charges with credit card companies. In all cases though, I take them to the Better Business Bureau if needed and close the account. I've only lost once, but the company lost a good customer of 8 years. And I'll never return to it.

The supply is large for someone with good credit, so being faithful to any single company is pointless.

Are "generics" a threat to drug companies?

Every time I read something about a drug company it always comes with warnings about fierce competition and the threat of generics. Fierce competition I can understand. There are many drug companies out there. But the threat of "generics" is something I started questioning recently.

The theory is that when patents expire, opportunistic drug companies will step in and produce the same drug for less and bring down the nice margins enjoyed by the original manufacturer of the drug. The nice margins were nice because the drugs were protected by patents. When this is no longer the case, goodbye profits. Or so goes the theory.

But does this really happen and is it really that bad?

Why can't drug companies lower their prices and compete head-to-head with generics when their patents expire? Are the big drug companies that inefficient that they can't lower prices enough to compete? They surely have better financial position than the generics. Given that they compete with other drug companies, I'd expect them to be reasonably efficient and be constantly lowering their cost structures.

Wouldn't some customers even pay a small premium to get a branded drug as opposed to a generic one? Of course some will, just look at sales of Tylenol compared to other generic cold and fever drugs. Anyone can mix paracetamol and acetaminophen cheaply. But Tylenol still sells more than others and people do pay a premium for the brand. Why wouldn't people pay a small premium for Plavix or Lipitor, two of the cholesterol-lowering drugs that are coming off-patent soon, the former by Bristol-Myers Squibbs and the latter by Pfizer?

Plus, is it really the case that big pharma companies cannot lower costs enough to compete with those like Teva, the israeli-based generic maker?

I simply don't believe that.

Assume the worst: big pharma is inefficient at running their drug factories (the plants that mix the powders and packages the pills -- all that is needed for a generic manufacturer). In this case, they could: 1) sell their "assembly line" and let a more competent operator run it, 2) buy one of the generic makers or 3) don't even bother with production and sales and worry only about development of new drugs. Many biotechs and smaller drug makers operate in the latter mode.

Now, suppose that this is not the case, that big pharma companies can lower their prices upon patent expiration enough to compete with generics. Then what happens? They now must compete on who has the most efficient sales channel, distribution and marketing teams, just like they had to do against their bigger rivals to begin with.

So, what does really happen? Let's see.

Let's look at three big-pharma: Bristol-Myers Squibb (BMY), Pfizer (PFE) and Merck (MRK) and compare them with generic giant Teva (TEVA), Watson Pharmaceutical (WPI) and Mylan (MYL).

What do they have in common?

BMY, PFE and MRK are all 3-star stocks as rated by S&P currently. Their analysts all "caution" us against "generic competition".

TEVA, WPI and MYL are all 5-star stocks as per S&P.

And yet, BMY, PFE and MRK trade between 9 and 12 price-to-earnings ratio, sport a 4 to 6% dividend yield and have return-on-equity that averaged from 22 to 34% over the last 9 years.

Compare these with TEVA, WPI and MYL trading between 14 and 43 price-to-earnings ratio, having dividend yields of zero to 1.29% and return-on-equity that averaged from 5 to 15% over the last 9 years.

The table below summarizes the comparison:


Note on methodology: I picked BMY and TEVA due to my own interest in them and then I randomly selected two others from each group. The big-pharma group I selected based on the first two names that came to mind and for the other two generics I picked the top two by capitalization. Of course, there are probably counter-examples to this situation too. P/E and div. yield from Google Finance. Avg 9-year ROE courtesy of S&P.

Conclusion: I don't buy the argument that generics are better investments (3 versus 5 stars), nor that generics create such a large threat. Sure, they eat into profits just like any competitor would. But the fear of generics does not justify, by itself, the low valuations of big-pharma nor a 5-star rating for the generics.

Disclaimers: None (no securities mentioned held long nor short at the time of writing -- though I'm considering starting a position in BMY, pending further analysis).