Holding Out for Dividends? Don’t

Looking for dividends is a lot like picking stocks, and Fidelity’s Peter Lynch’s know-what-you-own rule applies.

Looking for dividends is a lot like picking stocks, and Fidelity’s Peter Lynch’s know-what-you-own rule applies to finding companies with good payouts.

The name Peter Lynch elicits fond memories in the minds of investors throughout the last 30 years. If you aren’t familiar, or like me, weren’t old enough to remember him in his hay-day, Peter Lynch was the fund manager of Fidelity’s Magellan Fund from 1977 to his retirement in 1990. In several of his well-known books, Lynch attributed his success as a portfolio manager to eight fundamental principles:

• Know what you own
• It’s futile to predict the economy and interest rates
• You have plenty of time to identify and recognize exceptional companies
• Avoid long shots
• Good management is very important – buy good businesses
• Be flexible, humble, and learn from mistakes
• Before you make a purchase, you should be able to explain why you’re buying
• There’s always something to worry about

Each of these principles is important and valuable in building portfolios. I’d like to focus on the first edict: Know what you own. This is not to be confused with the concept of owning what you know – this idea has long been debunked; being wrought with survivorship bias and overconfidence.

Rather, this is a very basic idea of knowing the company in which you are (or intend to be) an equity owner. Let’s not forget, first things first, that purchasing stock in a company means that you become a fractional owner of that company. You gain when it succeeds and you have the right to vote in how the company is managed. That said it behooves you to know a little bit about what you’re getting yourself into.

I found myself in the throes of a real world example this week when researching the concept of optimal capital structure and dividend policy. In today’s low interest environment we are constantly looking for ways to provide our clients with potential yield – often that yield comes in the form of dividends. So I wanted to know – what’s the deal with all of these companies holding boat loads of cash? In the old adage of “fish or cut bait” I want growth through the use of retained earnings or I want my dividend!

So I went digging into the dark uncharted territory of the Notes to Financial Statements in a number of the largest publicly traded companies’ 10-k reports looking for answers. I was screening for companies that do not pay dividends but have large balances of retained earnings or cash and cash equivalents when I ran across the following excerpt:

Adjusted CostCash, Cash Equivalents and Marketable Securities Cash $8,066

LEVEL 1:

Money market and other funds $5,221

U.S. government notes $10,853

Marketable equity securities $12 $16,086

LEVEL 2:

Time deposits $984

Money market and other funds (i) $929

U.S. government agencies $1,882

Foreign government bonds $1,996

Municipal securities $2,249

Corporate debt securities $7,200

Agency residential mortgage-backed securities $7,039

Asset-backed securities $847

TOTAL $47,278

*In millions, as of Dec. 31, 2012

I bet you can’t guess what company this is. Now keep in mind, these numbers are in millions – that means this company has $47 billion worth of cash and cash equivalents; more importantly, $7 billion of mortgage-backed securities. Heck, I’ll even give you a clue— and it’s not a financial institution!

And that’s just the point – you would expect to find that nearly 15 percent of a financial institution’s cash and marketable securities were in mortgage investments – it wouldn’t shock you. Seven percent of total assets wouldn’t be hard to believe. You would know that your investment had exposure to the mortgage market. But that’s not what this is.

For better or for worse (and frankly, I’m not making a judgment call either way), this is the exposure you get when you invest in Google, Inc.  Google is considered by many to be one of the world’s most innovative and widely recognized companies. It’s so famous; it’s got its own verb! Investors in Google are expecting returns based on technological innovation, not how well their mortgage-backed securities desk can trade within their marketable securities portfolio.

Whether or not your view this exposure as a good thing or not is irrelevant. The point is if you went out and bought shares of Google expecting the majority of your exposure to be correlated with the cycle of innovation in technology, you’d find yourself exposed to interest rate risk, credit risk and myriad other risks that you wouldn’t have even considered if you hadn’t done your homework.

Like me, you’d also be expecting that all that cash not being paid out in dividends would be used toward developing new products, not proprietary trading (and if David Einhorn gets his way, you may start to see those beloved dividends).

And Google is not alone- there are all kinds of unexpected things lurking in the Notes to Financial Statements. Knowing the risks you’re exposed to is all part of knowing your investments. In the context of a portfolio, not knowing can distort total risk, something we all try so hard to manage.

So take a lesson from one of the greats – do your homework to be sure that when you purchase a stock, you know what you own.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.

Read this article on U.S. News & World Report…