Sunday, May 18, 2014

Not all dividends are created equal - take for example dividends paid in the resource industry.

Dividends are one of the best features of the stock market and dividend reinvestment is also a nifty investment strategy written about by numerous authors. But just like Buy & Hold strategies, they should not be applied blindly.  There is the theory that companies that pay out dividends don’t have a lot of growth left in them; they don’t know what to do with their profits, while companies that have a lot of potential growth ahead have numerous investment opportunities to apply all their earnings and thus are not supposed to pay dividends.

The growth companies, according to this theory are tax friendlier than dividend paying companies for the simple reason that dividends are taxable. Yet, compared to salary, interest income and rental income, dividends from Canadian companies are tax advantaged. Also, there are the stock buyback programs, where companies use part of their profits to buy back their own shares; especially when their shares are undervalued in the stock market. Share buybacks reduce the number of outstanding shares (in general) and thus future profits will be divided amongst less share(holder)s. Share buybacks are a tax free way to reward shareholders and sometimes they are therefore preferred by investors.  A lot of the choice between buybacks and dividends depends on the financial situation of individual shareholders. Some shareholders, in particular retirees, prefer the cash flow from dividends rather than the increased profits per share resulting from the share buyback (which is lot less certain than the bird-in-the hand dividend).
However, stock market performance studies by authors such as Jeremy Siegel or James O’Shaughnessy show that contrary to theory, the best dividend paying companies outperform the rest of the stock market, including the ‘growth’ companies. Also, the theory that non-dividend paying growth companies don’t provide cash flow is not quite true; it just provide a different kind of income! After all, nothing stops an investor to sell off a bit of its growth stock to cash in some profits to live off or for reinvestment in other opportunities.
The same is true for reinvestment of dividend programs such as the widely lauded Dividend Reinvestment Programs (DRIP). Yes, for individual stocks a DRIP may ‘cost average’ the purchase price of a stock holding. But an investor with sufficient self-discipline, may instead accumulate those dividends and re-invest in other better opportunities thus increasing his/her return possibly even more!  So, really there is no black and white about dividends, share buybacks, and growth companies.
Neither are all dividend paying companies the same!  Dividend aristocrats like Canadian banks, Apple, Johnson and Johnson are known to consistently grow profits in near linear fashion and thus every year or so those companies increase their dividend payouts like clockwork. These are the investments, when bought at the right price, make investors like Warren Buffett salivate. You can easily calculate their ‘intrinsic value’. You can put the shares of these companies nearly in a shoebox and discover that they have grown into a fortune a decade or two later. But… not all dividend paying companies are like that.  Resource companies such as oil and gas producers, gold miners, nickel and zinc producers, potash miners, etcetera are clearly a different ball game.
Many resource companies are cyclical in nature that means their share price goes up and down with the economy. Over the longer term many of these resource companies go little up in value and many others, yet again, go out of business during the down cycle. The reason is the short term view of many investors in this field.  Only the largest resource companies can escape this pattern and have long term business plans. Companies like Exon Mobil or Shell. Another company that displays this longer term thinking is Canadian Natural Resources Limited (CNRL) which is creating longer term value despite not being the same in size as the Shells and Chevrons of this world.  CNRL’s share price (stock ticker CNQ), is still a very volatile stock over the business cycle.  From its highs of around $50 per share at the peak of the previous cycle it went down nearly 50% but today it has recovered to $44 and I suspect that it will surpass its previous high during the next peak in the business cycle. Another Canadian oil company that shows similar traits is Vermillion.
However, the great majority of resources companies, including oil and gas with which I am most familiar show a highly speculative and capital destructive character. Many start at the bottom of the cycle, when competitors are in trouble and shedding assets abundantly. The upstart can obtain assets with its founding capital at rock bottom prices. Next it will exploit these properties often through the drill bit. Sometimes they only have to re-enter wells acquired as part of the new assets and recomplete a formerly producing zone or a new horizon. They can produce these assets often profitably because there are no significant legacy liabilities from previous business cycles. With an improving economy commodity prices will increase (the law of nature) and so will the profitability of the startup company while their management will look like ‘geniuses’.  But investors have no patience, they want to make a quick buck, so they drive the new companies and others that survived the recent cycle low to grow production and oil and gas reserves.  If these companies show no growth each quarter, these investors – or better speculators – will abandon the startup company in a heartbeat.  Also, the company’s management has a large portion of their compensation in the form of stock options; they are highly motivated to drive up the stock price as fast as they can and hopefully before the next cycle high!
As a result, many resource companies will try to grow through the drill bit, through acquisition either of weak competitors or by acquiring land. This is a highly competitive business and as soon as the upswing in the cycle starts, prices of land and companies will rise at incredible speed. Also, the costs of drilling wells which were relatively cheap at the bottom of the cycle when no-one could afford to drill explode up in this stage of the cycle.  So growing production and reserves will become rapidly very expensive. The companies take on debt and hire new staff at neck break speed; salaries and bonus are soon going through the roof.  In the meantime share prices and commodity prices are driven up, while corporate profits are going higher and higher.  There comes point where the commodity price peaks.  Oil and gas prices are so high that they impact, often along with interest rates, economic growth. Next the economy slows down.
As soon as the economy shows signs of slowing, commodity prices flatten or may fall a bit (10 to 20% is often enough). But then it is too late! The resource companies have loaded up on debt to keep on growing and their production costs are so high that they start losing money with even the tiniest fall in commodity prices.  The cycle has peaked; companies with shares often priced for perfection (or even higher) can no longer service their debts and start losing money.  Within a short time their value literally crash, dragging many investors – better speculators – with them down into oblivion.  If you don’t get out right away it may take you years to recover your net worth at the market peak and many of the companies won’t survive.
A significant number of resource companies these days pay a dividend which is most of the time not sustainable. Typically, a large portion of those dividends get cut; sometimes all the way to zero. During this last downturn even Encana did cut its dividend! Only very few get through the cycle without dividend cuts, e.g. CNRL. Every activist blames so called big oil and their imagined monopolies for manipulating the oil markets.  Not so.  Most of the time the industry is way too competitive and short term oriented for companies to affect pricing. This industry is an industry of price takers, oil and gas prices are often forced by politics (Obama’s dithering; a war), forced by the economy itself or even by the weather.
Investors lull themselves to sleep when they receive dividends from resource stocks, especially when the cycle lasts more than a few years. If you want to invest in dividends and dividend reinvestment, resource companies are NOT for you except if you invest in the biggies and even then their share prices are far from going up in a straight line. Investing in dividend aristocrats is a way to make money; investing in the large blue chips will make you rich, slowly.  Warren Buffett is the master in this field. However when Warren gave in to temptation a few years ago and bought Conoco Phillips even he got whacked by the vagaries of resource investing.
You can make a lot of money investing in resource stocks, but you must understand that this market niche has its own rules and investment strategies. It is not suitable for long term dividend reinvestment. Good hunting.


  1. Hi another great article.

    What is your opinion on a ETF index strategy, I like dividends but the market for potential buys seems to me to be expensive, for example the banks or telecoms or utilities like Fortis or Emera. I was thinking of some index etfs to park money while waiting for a possible correction. And how is Calgary as a place to live/place to buy housing?, Toronto has really gotten too expensive over the lasy few years and Calgary seems more reasonable.



  2. Hi Richard,

    If you buy individual stocks or you buy those stocks via an ETF does not make a lot of a difference. If you pay too much for an asset your performance will suffer. It is all about buying an asset's future earning's stream at the lowest possible price.