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THE DEVELOPMENT OF
discipline, valuation mattered and investors were willing to consider a variety of financial characteristics to identify cheap valuations. By the late 1970s, a few firms began to look at the historical relative yields of specific stocks and industries to build perspective on valuation. The perspective gained from looking at stocks compared to their own history, and com- pared to the market, was compelling. In the early 1980s, Roger Newell and Tony Spare, later my colleagues at the Bank of Cal- ifornia, adopted Relative Dividend Yield (RDY) as a way of identifying when stocks were cheap and when they were ex- pensive. In adopting this approach they understood that rela- tive information was going to be more valuable over time than absolutes (see Chapter 4, page 42, and Chapter 10, page 162, for additional discussions on relative versus absolute meas- ures). They were also interested in relative yield for the con- tribution to total return provided by consistent and growing dividends. The market yields were much higher then and a portfolio with an above-market yield could expect to receive half of its total return from the dividend.
The gradual development and adoption of new investment approaches is not a new story. Investment managers have always continued to search for new ways to profitably and reliably invest in the market, a search that continues to this day. However, the danger in this effort lies in the potential for constantly changing an investment approach depending upon the market of the day. There is a fine line between being completely open to new ideas and being fashionable, or driven by the trend of the moment. We have often said that having anyinvestment discipline is good. Having a good discipline is better. Trend following is a surefire way to lose money . . . lots of it. Over the years, many portfolio managers and their clients have given up on their investment strategy at just the wrong time. The compounding effect of chasing the in-vogue strategy after it has already worked and abandoning the strategy that is about to work is quite costly. Sticking with any strategy will pay off over time. Chasing trends is a poor man’s game.
THE DEVELOPMENT OF RELATIVE DIVIDEND YIELD 23
At the time RDY was first adopted, we managed money for wealthy individuals in the bank’s trust department of the Bank of California. Many of these individuals were in need of income; therefore, the logic of using a methodology around dividend yield was obvious. In the beginning we did not understand the compelling features of the discipline that we came to appreciate in later years, but Newell and Spare did find the relative yield discipline to be an effective way of buying and selling stocks for the income equity col- lective funds they ran at the bank. By the time I became in- volved in the management of the strategy, we were expanding our client base to demanding institutional, pension clients.
The challenging questions and rigorous review process helped us evolve our thinking and crystallize our strategy as we bought and sold stocks using RDY. RDY was not an original concept; the useof RDY as a valuation discipline for stock selection was.
Before going into the details of what RDY is, it is important to look at why it works. RDY avoids relying on earnings, which are cyclical and at times difficult to predict, particularly at turning points. Dividends, however, don’t require forecasting for the discipline to work. Further, the discipline reflects the policy of the corporate boards. Over time, we learned through our implementation of the RDY investing strategy, that the dividend was a good indicator of a company’s own expec- tations of future earnings growth prospects and its overall business stability. We learned that the companies we were in- vesting in tended to have “dividend-paying cultures.”
The fact is, most dividend-paying companies do not slash their dividends haphazardly in response to market condi- tions. The reliability of the dividend policy is what helps to make RDY a stable valuation benchmark. Company boards pay close attention to their long-term cash needs, as well as to the capital needs of the company and the economic condi- tions. They set their dividend policies so that the dividend can remain a relatively constant percentage of earnings in good
times and bad. For example, when oil prices skyrocketed in the mid-1970s, the oil companies did not greatly increase their dividends. Nor did they sharply cut their dividends when prices and profits plummeted about a decade later.
Figure 3.1 shows that, although Chevron’s earnings have gyrated over time, the dividend has remained stable, growing at a slow deliberate pace. As such, it is a proxy for long-term sustainable earnings power, and a powerful indicator for investors.
A stable dividend policy provides reliable information about how corporate management views the firm’s prospects for long-term earnings, as well as an income stream that is important to investors. The predictability of the income stream can be beneficial to investors, particularly in periods when the market is declining for longer than a few months, such as prolonged recessions.
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Per Share Dividend and Earnings Comparison Chevron (CHV)
Dividends
Figure 3.1 Per Share Dividend and Earnings Comparison Chevron (CHV) Source:Data from Compustat.
THE DEVELOPMENT OF RELATIVE DIVIDEND YIELD 25