Dividend investing is a means of building wealth over a long period of time with reduced risk. Many brokers offer fee-free purchases and reinvestments and the ability to reinvest fractional shares. Dividend investing is for the long term buy-and-hold type investor who wants to sleep at night while their investments steadily build.
Articles from The Prudent Investor
Alpha and Beta
Risk and reward are intertwined. Risk is acceptable if paired with an appropriate reward, and understanding how alpha and beta fit into the calculation is essential for the proper determination of risk.
“Successful investing is about managing risk, not avoiding it.”
I do not bother with lottery tickets. I can understand purchasing a single ticket for the entertainment value of imagining what one might do with the money were they to win, but from a risk perspective, it makes no mathematical sense. I have said that lotteries prey on the mathematically challenged, though there is one notable exception of which I am aware. Simple arithmetic can highlight its futility.
The odds of winning the big prize playing Powerball or Mega Millions are 1 in 292 million and 1 in 303 million, respectively. While I have heard it said, "someone has to win," I have a way of explaining the unlikelihood of winning. If you were given an envelope and told to deliver it to someone in the United States without being told who the person was or where they lived, and you happened to give it to the right person, then you would win the lottery. Otherwise, you would lose.
These are hopeless odds. When you offer a dollar for a ticket, then the odds of losing that dollar are not worth the investment. But it is possible to make it mathematically worthwhile. If the odds are 300 million to 1 against you, and the jackpot is $300 million, then the reward equals the risk. Of course, in this situation, the fact that it is possible for more than one person to win sullies the calculation. Alas, this article is about dividend stocks, not the lottery, but the basic idea of risk and reward is the same.
There is a level of risk attached to everything in life, and purchasing a stock always contains some element of risk. It is tolerable if the reward equals or exceeds the risk. I think of this each time I see someone shoot their car through an intersection. Yes, they will possibly arrive at their destination earlier, but does the reward of this possibility of getting to their destination 20 seconds earlier overcome the risk of an accident or that a red light camera may force the driver to pay a fine?
Alpha and beta are terms used to quantify risk in stocks. Examining the numbers for a stock can better help us determine the appropriate level of this risk.
Beta is a measure of the relative volatility of a stock to the market. Investopedia notes that it is calculated through regression analysis and defines the formula as, “the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period." I will let someone else do the calculation, as Yahoo Finance already has this covered. We simply need to understand what the value of beta means.
When a stock has a beta of 1, it means that its movements in price follow that of the market. As the market moves up, the stock moves up, as the market moves up a lot, the stock moves up a lot.
If a stock’s beta is greater than 1, then it has greater volatility than the market – when the market moves up, the stock moves up, but more. The higher the number, the greater the volatility. Conversely, if a stock's beta is less than 1, then it is less volatile than the market.
The value of beta is a multiplicative factor. One uses it as a multiplier, so a stock with a beta of 2 means that it is twice as volatile as the market (the market goes up, the stock goes up twice as much), and one with a beta of 0.5 means that it is half as volatile (the market goes up, the stock only goes up half as much). We often use the S&P 500 Index as a proxy for the market, so in this article, I will use them interchangeably.
Beta can also be a negative number, which indicates that the stock moves counter to the market – if the S&P 500 goes up, the stock goes down. This link offers examples of negative beta stocks. In such a situation a stock with a beta of -2 indicates that when the S&P 500 goes up, the stock goes down twice as much.
Beta, i.e. volatility, is a shorthand for risk. Stocks with a beta of 2 or more are considered to be high beta, or very volatile, low beta stocks hover closer to 0.
Beta is often driven by sector. Utilities are generally immune to the movements of the S&P 500, while the computer and software sector may drive the market’s swings. One seeking the calm may want to gear themselves toward low beta stocks, whereas those who are willing to deal with volatility may wish to expand to a higher beta value.
Alpha is the percentage difference between a stock’s gain (or loss) and its expectation. That expectation is often a benchmark, like the S&P 500. If the S&P 500 goes up 5%, and the stock has increased by 20%, then that yields an alpha of 15 (the difference between 5% and 20%). Reverse the numbers, and it offers an alpha of -15. A positive alpha outperforms the market, and a negative alpha underperforms.
It is a positive event when a stock has increased by 25% in a year, and most of us would be glad for that to happen. However, the S&P 500 returned 30% in 2019. While 25% may appear to be successful when isolated on its own, it has not performed as well as the market, so this indicates an alpha of -5, or 5% less than its expectation.
Alpha places gains and losses into context. If a rising tide lifts all boats, then alpha shows how much higher a particular boat might be over others in that rising tide. It is the difference between looking good because all stocks are looking good, and looking good through actual outperformance.
Using the Two Together
Both alpha and beta are backward-looking. Attempts to predict the future may be problematic, but the realization of a stock’s historical nature can give the investor an indication of what to expect. If we understand the volatility of a company and compare its actual fluctuation to that of the market, then we have a better idea as to whether or not the risk has been worth the reward.
For example, consider a hypothetical company that has returned 12% over a specified period, while the S&P 500’s return was 10% over that same period. The stock outperformed the index, so on the face, this is a positive event. The real question is whether or not the reward for owning the stock had been worth the risk.
This example stock shows a beta of 1.5, which means that its volatility is 50% higher than that of the market. As the S&P 500 returned 10%, 50% higher would have brought us a return of 15%. While this stock outperformed the market, only returning 12% gave us an alpha of -3, which means that the risk had not been worth the reward.
The advantage dividend investors have with this exercise is that when dividends are collected and reinvested, the dividends increase the total return of an investment, and reinvested dividends increase the number of shares. The ability to do both gives the investor a better chance for success toward a positive alpha.
But Does This Matter?
“Just when I thought I knew all the answers, someone changed the questions.”
The idea of beta and alpha is to have a means of numerically exploring risk and reward. If one is willing to assume higher risk, then they should receive a higher reward (as well as accept a greater loss). This is one of the basics of the Capital Asset Pricing Model (CAPM).
The problem is that in the real world, this may not be happening. In 1972 Merton Miller and Myron Scholes showed that high beta stocks underperformed low beta stocks. In other words, risky stocks had lower returns than less risky stocks.
Yuval Taylor wrote Why Low Beta Outperforms, which is interesting to the mathematically inclined. To those who wish to cut to the chase, he shows that there is a negative correlation between beta and alpha, and low beta stocks outperform their high beta equivalents. The bottom line is that while one should be rewarded for being exposed to higher risk, they may be more greatly rewarded by involving themselves with lower risk.
High risk should bring high rewards. Low risk may offer higher rewards. High beta stocks command that their performance compares favorably to the appropriate benchmark – low beta stocks demand the same. The use of beta allows one to work within a margin of safety when making a purchase, offering guidance in the issue of risk.
It is problematic that whereas exposure to high risk should result in a high reward, it is possible that a low risk could bring about greater reward. One should at least understand where the risk lies in their portfolio and take it into account when making decisions.
Other Articles of Interest
Learning from Dividend Reductions
In July Codorus Valley Bancorp, a company that has increased their dividend annually each of the past nine years, announced that they were cutting their dividend by more than a third. Examining the warning signals that preceded the decision can be instructive in alerting us to some of the signs of an impending dividend cut.
On July 15, Codorus Valley Bancorp, Inc. announced a Quarterly Cash Dividend of $0.10 per common share, down 37.5% from its previous quarterly dividend of $0.16. After nine years of consecutive annual dividend increases, the company is no longer listed in the Dividend Challengers list.
A while back I profiled First of Long Island Corporation (NASDAQ: FLIC), a small bank in New York City. They should soon become a Dividend Champion, to date having increased their dividend for 24 consecutive years. By examining the metrics in the article about FLIC, we may be able to realize some of the indications that would have given a heads up to Codorus Valley Bancorp’s announced dividend cut.
Gaining an understanding of success can help select companies that are beneficial to our portfolios. Articles fill the Internet offering such information, as is the case with numerous television shows. However, these sources are less than ubiquitous when it comes to taking note of failures in the making.
Perhaps this is because it is a much more difficult task. I hesitate to proclaim Codorus Valley Bancorp a failure because its dividend reduction may be what it needs to be a successful company in the future. Also, this measure of success may not be the same for different people. A company may be an excellent investment for one person but not another, as explained in Stock Tips are Bunk.
As a retiree, I have devoted a percentage of my retirement income to dividend companies, so a company's dividend is an essential part of my definition of success and failure. My finances hinge on a company increasing its dividend, which is where I place my importance - your mileage may vary.
I will explore Codorus Valley Bancorp by using the same general concepts as when I examined First of Long Island Corporation. As can be seen, evaluating just a few elements of a company can give one a head start in fully understanding the future of its dividend.
Codorus Valley Bancorp (NASDAQ: CVLY) is a small company when compared to others on the major stock exchanges, with a market capitalization of only $125 million. It places the company within the definition of a micro-cap, a publically traded company that has a market capitalization between $50 and $300 million.
Before looking at the numbers, one must understand the potential difficulties associated with micro-cap stocks. They tend to be more volatile and riskier than larger companies, as large purchases have more potential to influence the stock price. It also makes them prone to market manipulation. These issues increase the risk, which may be counter to the idea of dividend investing in the first place.
Almost as important is that there is less information available about micro-cap stocks. Fewer analysts cover due to reduced interest, so events that may influence the company are more likely to go unnoticed. It makes understanding price movements and management decisions difficult, which complicates the decision-making process.
Chart by Stock Rover
As can be seen above, over the past ten years, CVLY's stock price has had a long period of success, followed by a couple of declines. Starting at just under $4 in August 2010, it soared to over $28 in July 2018. Out of curiosity, I compared it with FLIC over that period, and on a price basis, it vastly outperformed.
Chart by Stock Rover
The two companies mirror one another, with CVLY offering wilder swings due to its greater volatility, so this is a good comparison.
A dividend investor requires a dividend worthy of consideration, so that is always part of the calculation. Codorus Valley Bancorp historically offered a yield in the 2-3% range, which was comfortable. When the coronavirus hit, the price plummeted, which meant that the dividend yield shot up.
This yield spike moved it away from its comfort range, which under the circumstances is not a surprise. As the stock price was cut nearly in half due to the virus, the yield, as compared to historical standards, fell out of its traditional bounds. The dividend yield became atypical – not necessarily a cause for alarm, but a data point with which one should have taken note.
The dividend payout ratio compares the total amount of dividends to the net income of the company, that is, the percentage of the profits that go to the owners. A ratio that exceeds 100% tells us that a company is giving more to the shareholders than they are making, which is generally not sustainable.
According to CSIMarket, the average payout ratio for regional banks in 2019 was around 30%, then jumped to 52% in the first quarter of 2020, then fell to 40% in the second quarter. This tracks with Codorus Valley Bancorp, at least until this past June.
CVLY’s payout ratio had been remarkably consistent since 2017 when it shot up to 56% in June. Whereas this value had been closely aligned with other companies, it was now considerably higher. Usually, a payout ratios under 60% is not cause for concern, as it is sustainable. In this case, the near doubling in a short amount of time must have been a shock to the board of directors. It was also a data point to those holding the stock.
The June 2020 edition of the Dividend Champions spreadsheet shows a reasonable growth rate for Codorus Valley Bancorp, 12.5% over three years, 10.8% over five years, and 13.2% over ten years.
When the share price is low, adding one cent to the quarterly dividend can result in an impressive percentage increase. However, at times it appears that the company was increasing its dividend by the absolute minimum to show that it was, indeed, increasing its dividend. Note the ups and downs over six years – by some definitions of Dividend Champions, they should have lost their status in 2017. Below I have extended the dividend to six decimal places through necessity.
Put graphically –
While Codorus Valley Bancorp was a Dividend Challenger and on track to move that designation up to Dividend Contender, note the increases and decreases, advancing and receding the dividend. It appears to have happened in fits and starts, as opposed to moving in a specific direction with energy.
Dividend investors initially look at three things – yield, payout ratio, and growth – to gauge the condition of the dividend. These are not all-encompassing metrics that tell a complete story but are essential starting points that can act as red flags or go signs. Evaluating these three values in perspective with industry and history offer a starting point at divining future decisions of the board of directors.
In the case of Codorus Valley Bancorp, the dividend yield moved into uncharted territory when its price dropped and was not able to respond. The same happened with the dividend payout ratio, as it climbed into an area it had not previously seen. The company increased its dividend each of the past nine years, but that history does not extend to the beginning of the last recession.
The previous recession was not good for CVLY's dividend. Its $0.14 dividend in January 2008 fell to $0.13 the following quarter, then $0.12 for the next three quarters before being slashed to $0.08, then finally $0.03. Some banks (like First of Long Island Corporation) were able to weather the storm, while others were not.
Dividend growth, when examined quarterly, appeared to advance haltingly. It was as if management grudgingly increased the dividend, not through desire but expectation. Despite the ability to increase the dividend, the will was absent.
With this knowledge, a shareholder should have seen the warning signs, known the company history during the last recession, and with the understanding that small companies have fewer resources to survive recessions, realized that a dividend cut was very probably on its way.
Sometimes dividend cuts take one by surprise, whereas other times they can be readily predicted. Paying attention to the described metrics and understanding a company's history can prepare one for what is to come.