Do Banks Deserve a Place in a Dividend Portfolio?

Earlier this week, we learned that Standard Chartered bank (a stock that I own) was accused by the New York Department of Financial Services (DFS) of engaging in illegal financial transactions with Iran. A worst-case scenario for the bank would be a loss of its New York banking license -- a possibly crippling action since so much money flows through the state of NY, and specifically New York City. The best-case scenario (save a complete dismissal of the allegations) would be a one-time fine and a temporarily tarnished reputation.

Pick your poison

From a dividend investor's perspective, the first case would be far worse as it could impair long-term profitability (indeed, StanChart keeps its accounts in USD) and increase the risk of a dividend cut or perhaps a rights issue. Assuming StanChart did, in fact, do something illegal a hefty a one-time fine should be relatively good news for dividend investors as the company's payout ratio is about 40%, so there's some margin of safety there to absorb a one-time shock. Plus, StanChart has excellent liquidity metrics and an industry-leading capital position. It would have to be a very severe punishment, in my opinion, to put the dividend at risk.

Just a few weeks ago StanChart increased its dividend by 10%, so if the firm knew about the DFS investigation it clearly felt comfortable raising the payout. If management didn't know about the DFS investigation then it either thought it was doing legitimate business in Iran or it was delusional enough to think they would get away with it. If management knowingly conspired or concealed transactions while at the same time heralding its reputation to investors in the recent conference call, that would be enough for me to consider selling my position.

However this plays out, this week's news has raised a number of questions and resurfaced concerns about bank stocks. If this can happen to Standard Chartered -- a self-proclaimed "boring" bank that successfully navigated its way through the financial crisis and had avoided all the scandals that plagued other banks (LIBOR, mis-selling products, etc.) in recent years -- what global bank couldn't this happen to? And more importantly: Do modern banks deserve a place in a dividend portfolio?

Times have changed

Dividend investors have been understandably apprehensive about bank stocks following the financial crisis, as the events clearly put into perspective the reality that modern banks are not the 3-6-3 banks that used to anchor many dividend portfolios. Today's global banks, by contrast, have opaque balance sheets and are more exposed to fat-tail risks (rogue traders, money laundering, etc.) that can quickly impair results.

As a result, today's banks are very difficult to value and you're thus putting a lot of faith in management's ability to make the right decisions. This is exactly why recent events at JP Morgan (the London Whale) and this week's story about Standard Chartered are so disappointing. Both banks have been held up as models for global banking post-financial crisis and the reputations of both firms have been questioned, leaving investors with fewer straws to grasp. If you don't trust the bank's management, it's hard to feel confident about the bank's future.

Worth the trouble?

So why bother with banks when there are plenty of good dividend-paying shares in "less risky" sectors?

I think it's completely understandable for a dividend investor to walk away from bank stocks given events in the last five years, but it's important to keep the following things in mind before making that decision:

1.) If most investors are walking away from bank stocks, that could be an opportunity for contrarian investors to make money in the long-run.

2.) By managing your own portfolio, you get to determine how much exposure you want to certain companies and sectors. If you're cautious about banks but think there's opportunity, make them a small percentage of your portfolio so they can't do permanent damage if things go south.

3.) Sufficiently capitalized banks with good liquidity should be better able to deal with periodic shocks to their business without cutting the dividend.

4.) After the carnage of the financial crisis, banks have a vested interest in building dividend momentum as a sign of improving health.

I should note that this was part of my thesis for Standard Chartered, so time will tell if it holds water.

Look before you leap

StanChart will remain a small part of my portfolio for now, but I don't anticipate adding any other bank stocks to my dividend portfolio in the near-future. Some stocks are just simply not worth the trouble, even if they're potentially undervalued, and I think most global bank stocks fit that bill today. There are plenty of alternative investments out there with more transparent balance sheets, higher dividends, and better cash flows and are easier to value, as well.

Whatever you feel about big bank stocks, be sure to approach them with eyes wide open. Times have changed and today's banks aren't the banks of old -- their dividends are riskier and you should demand a meaningful margin of safety given the heightened uncertainty.

Why Fewer Buybacks and More Dividends Would Be a Good Thing

Since certain financial regulations were loosened by the U.S. Congress in 1982 (rule 10b-18, to be specific), company stock repurchases -- commonly known as buybacks -- have rapidly become a preferred means of returning cash to shareholders. With buybacks, companies use cash on hand to purchase their own stock in either the open market or via tender offer. This reduces the company's share count and effectively increases ongoing shareholders' percentage ownership of the company. To put it another way, your slice of the pie stays the same while the pie itself gets smaller. 

Sounds innocuous enough, right? Who doesn't like pie?

From the company's perspective, there's really a lot to like about buybacks -- for one, they're more flexible than dividends (less commitment), they can be used to manage EPS (a figure Wall Street loves to focus on), adjust the firm's financial leverage, offset share dilution from employee stock options and grants, and provide a "signal" to the market that management thinks the stock is undervalued.

But from the individual investor's perspective, the benefits of buybacks aren't quite as clear.

The good, the bad, and the ugly

Stock buybacks, when used appropriately, can be a long-term shareholder's best friend if -- and only if -- the stock is undervalued when repurchased by the company and there are no better investment options. It's really that simple. When this is the case, there's a wealth transfer from former shareholders to ongoing shareholders.

The problem is that executives don't have a great track record buying their own stock, at least when it comes to investing shareholder money (investing their own money is a different story) and frequently overpay. This excellent paper by Credit Suisse, for example, found that "It looks like most of the buybacks by the S&P 500 over the past eight years have not yet added much value for remaining shareholders." 

Source: Credit Suisse

Long-term buy high and hold

So why do companies consistently buyback their stock at elevated levels? I think there are two prevailing reasons. 

First, when business is good, companies have more spare cash to put to work, but most companies' good years are positively correlated with good years in the market. As a result, not only is their own share price higher, but acquisition opportunities are also more expensive. Holding too much cash can be a bad thing, too. So what to do? Because raising a regular dividend is seen as a commitment to pay that amount or more going forward and investors don't like dividend cuts, companies don't want to over-commit to a higher payout if they aren't sure they can afford it when business dries up. Buybacks are an easy and typically well-received decision from the investor base, so they've become the default option when there's extra cash on hand

The second reason is that, in aggregate, there appears to be a lack of due diligence and proper valuation work being done in the executive suite. Even if we assume that all executive teams intend on repurchasing stock only when they consider it undervalued (and not for another reason), based on the studies we've seen, they're clearly not doing a good job of assessing their intrinsic value.

Any company (or investor) can adjust its valuation model to show that the stock is undervalued. A little lower discount rate here, a touch higher growth assumption there (model garnishing, as it's called in the industry) and voila -- your stock is undervalued. Indeed, this recent article in the Harvard Business Review illustrates quite nicely the quixotic valuation assumptions used by companies when making investment decisions. It's unlikely that you'll find a corporate finance team that wants to report to the CFO that the stock is overvalued.

At the risk of adding to the investing hagiography of Buffett (to which I've already contributed a great deal), I thought this passage from his latest annual letter to Berkshire Hathaway shareholders explained proper usage of buybacks quite well.

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (my emphasis)

Notice that Buffett specified a material discount -- for buybacks to create substantial value for ongoing shareholders, the stock must offer a superior return to what investors could get from a market index fund. Otherwise, hand back the cash and let investors earn a lower-risk market return on their own.

Some buyback proponents argue that if you own the stock, you are doing so because you also believe the stock is undervalued and therefore you should be fine with the company buying it, too. Not necessarily. For one, long-term shareholders are generally not interested in selling a stock if it's slightly overvalued, particularly if they're receiving a good dividend from the stock or if they'll have a large tax bill if they sell the full position. In addition, even if the stock is just slightly undervalued, there may be better opportunities elsewhere and ongoing investors should prefer to have the cash back to reallocate to those opportunities.

Others argue that if you want a dividend, simply sell a proportionate number of shares after the buyback. This might be fine for institutional investors with large positions, but for individual investors with smaller positions, this is less feasible due to transaction costs.

Is there no other way?

Few companies have consistently bought back their stock only when it was genuinely undervalued. As such, it would be great to see more companies adopt a "special dividend" policy in which they pay out all spare cash to ongoing shareholders each year after all capital investment needs have been made. Here are a few reasons why this is a worthwhile policy for companies to consider:

1. It consistently rewards ongoing shareholders rather than giving the cash to former shareholders; therefore, it might attract investors focused on the next 3-5+ years and not the next 3-5 months, giving management a little breathing room to make longer-term investments. 
2. It lets investors decide if the stock is undervalued. If it is, they'll reinvest the proceeds themselves.
3. It still provides room for smart buybacks when a clear case can be made for them.
4. It solves the "What are we going to do with this extra cash?" problem.
5. It forces management to become more thoughtful about acquisitions. While investors shouldn't expect a special dividend to be held steady year-over-year like a normal dividend, they'd also feel the loss if their special dividend was squandered on a dumb acquisition.

Here's to hoping more companies consider special dividends as an alternative to buybacks, but I won't hold my breath. Buybacks, love them or hate them, are here to stay. Whether you're evaluating a new investment or an existing one, pay attention to management's track record of buybacks. If they've consistently bought back shares in bull markets and not in bear markets, it's fair to question the process behind their capital allocation decisions.

What do you think? Please post your comments below.

Enjoy the Olympics!

Best,

Todd

@toddwenning on Twitter

(long BRK-B)