It's widely documented that over time, stock dividends provide a significant portion of the overall return on investment. Yet, the value creation assumes several implications. First, the shares are held long enough for the dividend to create meaningful value. Second, the dividend can be counted on for the foreseeable future.
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What Matters Most
Even if dividends create tremendous value over the long run, that reality means nothing to an investor if the underlying stock starts to decline significantly. Although a stock decline implies a higher dividend yield, in most cases such as an abnormally high yield, it will not last for long. Remember the dry bulk shipping industry? So, it's silly to chase dividends that are coming from unreliable companies. Instead, if one can find a company with strong prospects of maintaining and even increasing the dividend payout over time, there is a good chance that the company's stock price will also do well for investors over time. Believe it or not, today's banks may offer that opportunity of solid dividend payouts and growth potential.
Starting all over
Before the financial crisis hit in 2008, many of the largest financial institutions were considered consistent dividend payers, thanks to solid growth prospects. That idea came to a screeching halt when the credit markets froze and housing collapsed. Virtually all of the banks eliminated dividends as a way to preserve capital. As a result, those banks lost a wide base of investors who were rightfully concerned about the future solvency of the banks.
Fast forward to today and the picture is changing. Banks are cleaning up their balance sheets and capital ratios are vastly improved. Dividends have come back to some, while others are likely to reinstate the dividend as soon as regulations allow. In addition, bank shares remain at attractive valuations after a 50% drop in 2011. While 2012 has been a great rally so far for banks, the share prices in some cases do not fully reflect the tremendous progress. Going forward, banks have the opportunity to provide solid yields and stock price appreciation.
JP Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) are good examples. After the recent round of stress tests, JPM announced another dividend increase along with a stock buybacks. Shares now trade for $45 and yield 2.7%. Last year, shares traded as low as $27.85 and buyers at that price are now picking up close to a 5% yield. Going forward, JPM will likely increase its yield again. Wells Fargo also yields 2.6% and Warren Buffett continues to buy the shares. When feasible, Wells Fargo will likely boost its dividend payout. For related reading, see The Kingpin Of Wall Street: J.P. Morgan.
One name ready to boost its dividend is Citigroup (NYSE:C). Citi currently pays out 4 cents and a negligible yield of 0.1% at today's share price of $37.70. But management realizes that its shareholders deserve a higher dividend, and as the company continues to improve its capital ratio, a dividend increase is expected. With shares trading at about 60% of book value, there is plenty of room for long-term share price appreciation. AIG (NYSE:AIG) is another large financial name that will one day start paying dividends. Shares trade at 50% of book and 10 times forward earnings.
In short, banks are starting all over again. They eliminated the dividends to shore up balance sheets and conserve capital. Going forward, bank executives are likely going to maintain a very cautious approach as to not risk a repeat of 2008. One of the best ways to illustrate that is by paying out dividends.
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At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.