Investors: [Do Not] Yield to Oncoming Analysts!

Investors have a difficult task. There are thousands and thousands of stocks to choose from, many bonds to consider, futures and options related to these and other things, commodities, etc. In order to derive a true understanding requires a lot of research.

In order to assist, and market, “sell-side” analysts arose to do some of this work for the investor, and communicate succinctly the critical and important information while discarding the rest.

There was a sell-side analyst report I ran across the other day which touted as an investment benefit the high dividend yield of the stock compared to its peer group.

Wait a sec – is that right?

Pros

On the positive side, a higher dividend yielding stock does offer some “downside” protection. As long as the dividend is considered relatively safe, then there should be value attributed to it, and thus the stock price has some kind of floor related to it due to this dividend.

Cons

On the downside, dividend yield is usually correlated with interest rates, so as they move the price of the stock can move against you even if everything else remains the same.

But even more darkly, what if we believe the economic theory (covered in earlier posts) that the market price of a security does in fact reflect the best information available to all investors? If we believe this, then the dividend has a higher yield for a reason. And a good one.

Valuation

The price of a stock using the Dividend Discount Model, in its simplest format (there are more complicated representations), is:

Simply stated, the price of the stock (P) is equal to the dividend of the stock (D), discounted by an appropriate cost of capital (k) less growth expectations of the dividend (g).

Rearranged to reflect dividend yield, this equation becomes:

The dividend yield therefore reflects the cost of capital in relation to the growth prospects of the stock.

In a situation where we consider two stocks, one with a yield of 6% and one with a yield of 3%, the difference between the two is due to k-g. This means, at the two extremes, either:

a)      the cost of capital for the higher yielding stock is higher by 3%, which means the risk inherent with that stock is greater than the other.

b)      The growth expectation of the higher yielding stock is lower by 3% than the other.

Of course, it could be a blend of the two anywhere between a and b.

The point here is that the higher yield is due to a combination of greater risk and/or lower growth. Last time I checked neither of these are attractive situations, sell-side analysts notwithstanding.

So how can a higher yielding stock be a good idea?

Consider the Possibilities

If we take the position that the market might not reflect the true possibilities (a heresy to my alma mater!), then it might be possible we are taking on less risk than we are being compensated for. Using a casino analogy, under normal conditions the odds are in the houses favor, but if we end up at a blackjack table that pays 5:1 for a 21 then it might be advantageous to play.

Alternatively, we might be getting growth “for free”. Not a bad deal.

However, this ultimately means that even the sell-side analyst reports cannot just be consumed or acted upon… as investors we need to make sure the investment makes sense according to ourselves and our work.

So, in some respects we are back to square one – we as investors need to evaluate the merits and prospects of our investable universe. An analyst report might be one facet of information, but only we, and we alone, can decide the merits of its content.

I would love to hear your thoughts about investment valuations or your stories on this topic if you have them.

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