Signalling theory pays off for General Electric (NYSE:GE) investors
Today's Financial News - Posted December 11, 2008
Few investors are turning to income-generating investments while the economy tanks. But investors that know their history, will turn to dividends with expectations of strong profits.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): You have got to be crazy to be searching for dividends these days. With the economy in the gutter, payouts are getting slashed and many are getting erased. Buy a stock for its dividend payouts and you are asking to loss money. Right?
That is what many investors and investing-world pundits are saying. They are wrong.
If you study history and what really happens when dividends are issued, you would have the weapons necessary to fire back and shoot their troubled logic out of the sky.
Before I go any further, I fully understand a lot, perhaps the majority, of dividends will be slashed over the next few quarters. But that does not mean there are not a handful of companies out there maintaining and even boosting their payouts.
Two perfect examples are economic heavyweights, General Electric (NYSE:GE) and Nucor (NYSE:NUE). Investors at both companies were positive they would see their dividends cut, but management stood its ground and said payouts will remain strong. That is one of the most profit-creating moves a CEO can make for his shareholders.
Follow the signals
While it is an often-debated subject, I am a big fan of signaling theory. This is the notion that suggests the insider knowledge at a company should be considered with much more weight than the perceived knowledge of a supposedly efficient market. In other words, CEOs and corporate boards know their business far better than even the most well-connected Wall Street analyst.
Nobel-prize winners Merton Miller and Franco Modigliani helped make this notion famous when they released a groundbreaking study on dividends and their impact on share price. While it does not compare to their capital structure work that earned their award, it created quite a buzz among traditional investors.
Right now, investors in companies like GE and Nucor are using the academic duo’s wisdom to rake in profits. In early November, GE shareholders were barraged with near-constant threats of a dividend cut.
With GE Capital’s losses mounting, pundits were positive a cut was in store. But corporate executives promised on numerous occasions the company’s $1.24 dividend would stand. As soon as they did, I told TFN readers to start buying shares.
If they say so
It was a surefire signal that the company’s management had full faith the company would remain profitable and strong. Since GE’s latest dividend promise on December 2, share price has risen by more than 15%. If you go back to earlier, unofficial announcements in November, the gains approach 40%.
Shares have not risen solely because investors want to get the dividend. They jumped because GE has since announced margin-boosting changes to its Capital division and other businesses.
The important thing to realize is when the dividend was reiterated, Wall Street had no idea what changes were in store, but management did. Executives knew the company could afford to pay its investors. They are the ones with all of the inside knowledge.
It is signaling theory at its best.
Today, Nucor is making steps similar to what GE has done over the last month. Even though the steel industry is in the dumps right now, the company’s CEO assures investors that the dividend is here to stay and profitability will remain throughout the next year.
Nucor’s payout is drastically smaller than GE’s, but this is a certain indicator of the management teams outlook. After all, if they are wrong, it is their job on the line.
Savvy investors will take advantage of this positive “signal” and see if shares of Nucor are right for their portfolio.
Next Article: Financial Predictions 2009: The China Syndrome
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