Essential to Preserve Capital in Dividend Investing

701183_moneyAs dividend investors, while it is important to focus on dividends, it is also equally important to monitor the risk of capital erosion over a period of time. Dividend growth and intermediate sustainability is good, but it is less likely to be a substitute for significant loss of capital. Pfizer and GE are examples of capital erosion. These two companies were not only able to sustain their dividends but kept with their growth in last decade. However, the value of individual’s holding kept eroding over the last decade or so. For example:

    • PFE was trading around $43 per share from 1999 to 2002. In last couple of years, it has been trading around $16. At the same time, it has paid cumulative dividends of only $8.22 per share.
    • GE was trading around $40 per share from 1999 to 2002. In last couple of years, it has been trading around $18. At the same time, it has paid cumulative dividends on only $9.00 per share.

    In recent days, four companies viz. BP, Johnson & Johnson, and Procter & Gamble, and Toyota Motors are (were) getting quite a bit of attention in news media. Rarely a day goes by when their woes, or management response to product issues, are not discussed in the financial media or general TV news channels. Three of these four corporations also happen to the good dividend paying companies.

    Johnson & Johnson is one company that had been widely praised for its response Tylenol cyanide poisonings in 1983. JNJ took swift actions on recall and tamper proofing the product, even at the cost of loss in short term market share. The products market share temporarily dropped from 35% to 8%. In this case, JNJ regained the market share in next couple of years.

    • McNiel, a JNJ subsidiary, is in the news for recalling 43 over the counter medicines that are believed to be contaminated. As of this writing, it has had four recalls in last six months (i.e. late 2009 and early 2010).
    • The recall of Tylenol is not that unusual. Not long ago, in 2008, Tylenol was recalled due to manufacturing problems. JNJ was issued stern warning from FDA for violations and failing to report and investigate the problem quick enough. With the re-occurrence of this problem, it seems measures do not seem to be working.
    • I do not believe JNJ will have any noticeable impact on its financials because Tylenol, and other related recall products, have only $0.5billion contribution to $15.6 billion revenue. This is probably the reason there has not been a significant impact on JNJ share price.
    • However, it is these kind of events that affects perception and have impact on longer term.

    Procter and Gamble has been in news due to concerns related to its new product performance. Apparently, the new diaper product, Dry Max, which replaced the old product (Cruisers and Swaddlers) is causing rashes among kids. While I like PG’s continued stream of innovative products, managements initial response to this issue leaves lot to be desired.

    • For quite a few weeks, there was a growing concern. All PG did was plain rebuttal and termed it as false rumors. This issue also has a Facebook fan page with more than 10,000 members.
    • It was only recently that PG muscled marketing team to engage with community to convey their side of the story. While this issue is still open, U.S. Consumer Product Safety Commission launched an investigation last month.
    • To me, PG’s response to this concern was nothing to cheer about. Instead of offering rebuttals, it should have engaged with the community from the beginning. They should have understood the significance attached to its products. While it may not be dangerous, the questions around quality of its new product will affect its brand image.
    • Pampers is a brand with more than $5 billion revenue. It may not affect in short term, but slow erosion can have a long term affect.

    BP is other companies facing headwinds due to due to oil spill in Gulf of Mexico. Here also, a lot remains desired regarding to BP’s readiness for such disasters and its initial response.

    • It is hard to believe that a company can go in deep seas to explore and find oil, but was not capable enough to anticipate risk factors. There does not seem to have any indication that it had Plan B or Plan C.
    • It is also hard to believe that, at first instance, the company did not correctly anticipate the scope of spill and/or quantity of oil flow.
    • In addition, it’s also had a fire in refinery in Texas.
    • All this demonstrates something is wrong with the management focus.
    • Even though BP continues to maintain its dividends, which I do not think it can or will, it will affect its brand image. Over long term, the slow erosion will affect BP’s balance sheet.

    It is easy to look back and decide based on past performance. However, it is the sustainability of dividends and value of capital in future that matters the most. This sustainability is driven by brand image and moat of a given company. Both go together and may feed into each other. Brand image is something that we can observe because it is more about conversation and media coverage (good or bad). It is more about how consumers are reacting to company events.

    The power of great brands is indisputable. Often investors pay more for business with brands because they provide moat. Contrarily, businesses will have to develop certain moat over a period of time in order to develop that brand image. Brand image and business moat is something that management needs to protect and sustain over a period of time.

    It is common in business for things to go wrong. However, it’s the management response to such event that affects brand image. In case of JNJ and PG, I do not think there would be any financial impact in short-to-intermediate term. Managements that continue to use this type of approach in problem resolutions will be lead to slow erosion of value. In case of BP and Toyota, no amount of dividends will replace the loss of capital.

    One Response to “Essential to Preserve Capital in Dividend Investing”

    1. Steve says:

      I just wanted to say I always learn something when I come to your blog! Keep up the great work…

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