American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Oct. 2003 – Eastman Kodak Cuts Its Dividend

On Thursday, September 25th, Kodak announced that it would reduce its dividend to a semi-annual payment of $0.25 per share ($0.50 annually) from a semi-annual payment of $0.90 per share ($1.80 annually). The board declared a cash dividend of $0.25 per share, payable December 12, 2003, to shareholders of record as of the close of business on November 3, 2003. The announcement was made the day after the September Investment Guide had gone to press.

As a result of this reduction, Kodak fell from its position as the highest yielding of the thirty stocks that comprise the Dow Jones Industrial Index. As of the next day’s market close, the shares had fallen to 14th highest-yielding and were therefore no longer eligible for purchase in the 4-for-18 model. The high-yield Dow approach has been successful largely because shares are sold from the model after their relative yield has fallen, and in the overwhelming majority of cases this has been a result of share price appreciation, rather than a dividend that has been reduced. However, as we explain below, Kodak’s dividend cut and its resulting removal from the list is not unprecedented, nor is it necessarily calamitous for those who have the discipline to stick to the model.

In the aftermath of this announcement, we have received inquiries regarding what course of action should be taken. Interestingly, while some readers and clients have been asking whether they should immediately sell their shares, apparently sensing a continued rout, others have been eager to buy more, evidently detecting a bargain. In short, the rational response is to ignore your emotions and stick to the model.

To further explain our reasoning, let us first dispense with an argument we hear quite frequently. Callers invariably refer to what they have paid for the shares they currently hold, and then suggest some course of action. Some believe that because their average cost basis is so high they must “cut their losses” and immediately sell out their entire position. Others argue the opposite, that perhaps they should add shares in order to bring their average cost down further.

Both of these arguments are fallacy. The price paid for your shares of Kodak, or any asset for that matter, is a sunk cost. One cannot go back in time and change that decision; it is therefore extraneous data and does not merit further consideration. One should consider what to do with the shares held without regard to what was paid for them. One can continue to hold the shares, which will have some future, unknown value. Alternatively, the shares could be sold and invested in an alternative asset, which will have its own future value, presently unknown.

Which asset will have greater value will be determined by a myriad of factors that will emerge as news—that is, presently unknown information—earnings announcements, interest rates, etc. However, the price you might have paid for those shares once upon a time is not among the factors that will determine the future price of those securities. (Your cost basis is relevant if you hold shares in a taxable account, but it has no bearing on the future value of the shares).

If Kodak maintains its ranking of 14th highest yielding, or otherwise remains out of the four highest ranking stocks over the next 18 months, it will be incrementally sold off and replaced with whatever stock moves into the top four over that period. At such time its price might be higher or lower than it is today. We have no way of knowing that outcome. However, while it is rare for a high-yield Dow constituent to cut its dividend, there is precedent, and it is worth considering.

Consider the accompanying chart. There have been only nine instances during the past 25 years when a stock was sold out of the HYD model after a dividend cut had reduced its yield. We have depicted the (indexed) price performance of 8 of those stocks during the 18 months following the announcement of the dividend cut. Clearly, some stocks, such as Woolworth and Westinghouse, did poorly, while others did quite well. We omitted Goodyear Tire because its subsequent price appreciation was so great that its inclusion would have distorted the chart (its ending index value was 3.79).

While it is impossible to determine in advance which path Kodak might take, it is apparent to us that it would be unwise for an investor to “dump” his shares now. There is also a lack of compelling evidence to deviate from the model by adding shares now that the stock has left the model. The central point to keep in mind is that, despite occasional instances of stocks in the model that were sold at losses, these “losers” have been more than offset by the returns of “winners” that were purchased cheaply and sold dearly.

We should add that Kodak’s move runs contrary to the current trend. The recent change in the law that reduces the tax on dividends to 15 percent has prompted many corporate boards to increase their dividends dramatically. Other things equal, we expect this consideration will make it even less likely that stocks in the model will experience dividend reductions.

If you have found this experience to be especially worrisome, you might reconsider your risk tolerance. If you conclude that you are more risk-averse than you had assumed, you might reconsider your overall portfolio allocation. We recommend that most investors limit their total portfolio’s exposure to large cap value stocks to no more than 35 percent (conservative investors should target 20 percent). However, that 35 percent could be diversified beyond the high-yield Dow stocks. You might consider some combination of a high-yield Dow portfolio and one of our recommended large-cap value index funds. This will provide far greater diversification within the asset class, and can be expected to mitigate the sharp swings—up and down—that will occur with a the high-yield Dow portfolio alone.

Also in This Issue:

Quarterly Review of Investment Policy
Smart Tax Strategies
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield