By Tom Dyson | 29 October 2008
My professor placed his marker's cap against the whiteboard and pressed it so hard with the butt of his eraser, the cap fired into the ceiling… "This is what happens to share prices," he told the class, "when dividends rise and yields fall at the same time."
I used to work for Salomon Smith Barney, in the London office. I calculated the profits for a group of traders on a bond trading desk. After I'd calculated the daily profit and got each trader to sign off on my numbers, I reported the daily results to management.
Then at the end of every month, we'd tie all the results together and build them into the financial statements for the London office. A sloppy job would catch the attention of regulators. A cohort of auditors thumbing through paperwork on the trading floor was the last thing Salomon was looking for.
So Salomon wanted us all to be experts in accounting. The company sent us to accountancy school three nights a week. Everyone in my class came from major investment banks, hedge funds, and British industrial companies. We all worked 10-hour days for our firms and then took the Tube across London to spend another three hours discussing financial reporting standards in front of an overhead projector.
It was hell to stay awake. And the teachers knew it. So they'd make extra effort to keep our attention. One teacher, Professor Howard, loved to use physical demonstrations to explain things. One time, he passed money around the classroom to explain credits and debits… Another time, he made us act out a corporate board meeting to see if a merger was going to work. To show what happens when a stock's dividend payment rises while its dividend yield falls, he fired his pen's cap into the ceiling.
The Master Limited Partnership (MLP) Sector Is A Perfect Illustration Of Howard's Point
Right now, the Alerian MLP Index trades at 205 and pays $21.6 in dividends per year… for an annual dividend yield of 10.5%. The MLP Index has paid larger and larger distributions each year since 1996. This year, the sector is booming. Distributions from MLPs have risen almost 20% in the last 12 months. I think the boom in MLPs will continue, but to be prudent, let's assume dividends grow at only 10% per year for the next three years.
What about the dividend yield? Since 1996, the dividend yield on the MLP Index has fluctuated between 5% in times of optimism and 13% in times of pessimism. Right now, it's at 10.5%… indicating investors are fairly pessimistic toward the MLP sector.
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Dividend yields swing like pendulums. They swing from overvaluation to undervaluation and back to overvaluation in multiyear cycles. In the end, they always revert back to normal levels. Sooner or later, the MLP Index's dividend yield will revert back to normal levels... say, around 8%.
So let's assume this recession blows over, investors stop panicking, and dividend yields in the MLP sector return to 8% in three years. With 10% annual dividend growth, annual dividends on the MLP Index will increase to $29 per year. A dividend payment of $29 and a dividend yield of 8% together mean the MLP Index will reach 362… an increase of 77% from today's level.
Now that was a lot of numbers, but the idea is simple: When dividend payments increase (as they will in the MLP sector) while dividend yields fall back to "normal" This phenomenon works with any security that raises dividends every year for many years in a row. To make huge gains, buy when the dividend yield is near the top of its historical range and wait for it to decline to average levels.
If you can find a company or an industry headed for a dividend squeeze, you need to jump in with both feet. The squeeze should send your stock through the ceiling.
Good investing,
Tom
P.S. To calculate a stock's historical dividend-yield range, divide historical share prices by the historical dividend using data from Yahoo Finance.
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