The Dynamic Dividend

Seth Klarman’s Dividend Picks: Solid Yields at a Discount

Seth Klarman is widely regarded as one of the most intelligent and successful value investors of all time, and the numbers back it up. Since founding The Baupost Group in 1983, his firm has returned nearly 20% annually.

In addition to his impressive track record, Klarman has also penned one of the most sought-after investing books, which has turned into an economics lesson in its own right. Margin of Safety is no longer in print, but that doesn’t mean it’s not in demand: Used copies are sometimes seen listed on Amazon, usually for upwards of $1,000.

Baupost manages more than $20 billion, but a relatively small amount of the firm’s capital is currently in stocks. Klarman runs a concentrated $2.4 billion equity portfolio which currently owns only 21 stocks, so when he invests in a company he usually does so with conviction. Such has been the case with the only two dividend stocks added to Baupost’s equity portfolio this year, each of which appear to be very cheap right now.

Baupost started accumulating shares of Microsoft (MSFT) and BP (BP) during the second quarter, and the two companies already comprise more than 23% of the firm’s equity portfolio, according to GuruFocus.com.

Microsoft (MSFT)

The Baupost Group initiated a huge position in Microsoft during the second quarter, purchasing 12 million shares. That quickly made it the firm’s third-largest stock investment at the halfway point of the year, representing 12.9% of the firm’s equity portfolio.

Microsoft began paying a quarterly dividend in 2004, and has raised its dividend output by at least 10% every year since, doubling its payout in the process. The company traditionally increases its dividend each September, most recently giving its shareholders a 23% raise last year.

Many have called for Microsoft to be more aggressive with its dividend hikes, and with a huge cash hoard and a forward payout ratio of just 20%, they could certainly afford to do so. But the software giant holds most of its cash overseas, and bringing it back to the U.S. for dividend purposes would result in a hefty tax bill. The company (and its shareholders) would be a huge beneficiary of a repatriation tax holiday.

Shares of MSFT are currently trading at $25.10, where they feature a 2.55% dividend yield. That’s just 7.6% above their 52-week low and less than eight times the consensus earnings estimate for next year. When you back out the more than $6 per share Microsoft holds in cash and equivalents, the stock is actually trading closer to six times future earnings.

GuruFocus.com estimates Klarman paid an average of $25.04 for his huge block of Microsoft shares, which is a slight discount to the stock’s current level.

BP (BP)

Klarman purchased 5.5 million shares of BP during the second quarter, making it Baupost’s fifth-largest equity position (10.1% of the entire stock portfolio) at the end of June.

The international oil and gas company had increased its dividend output for nine consecutive years (and 15 of 16 years) heading into 2010, but that streak was broken by a horrific year (financially, environmentally, you name it). The company agreed to create a $20 billion “spill response fund” following the Deepwater Horizon disaster, and financed the account by cutting its capital spending budget, selling assets, and — yes — halting its dividend. The company reinstated its payout earlier this year at half its pre-spill size.

BP’s American Depository Shares are currently trading at $40.17, where the reduced dividend produces a very attractive 4.18% yield. That’s more than the yields carried by rivals Chevron (CVX), ExxonMobil (XOM), and ConocoPhillips (COP), which currently pay 3.25%, 2.61%, and 4.00%, respectively.

In addition to having a fatter yield, the stock also trades at a discount to its peers according to common valuation metrics. Its forward earnings multiple (analysts expect the company to earn $7.44 per share in 2012) is a paltry 5.4, while its price/book ratio is just 1.18. None of the aforementioned competitors (all of which appear cheap in their own right) are trading at less than 7.19x future earnings or 1.28x book value. According to Morningstar, the average stock within the industry trades at 9.2x earnings and 1.5x book value.

GuruFocus.com estimates Klarman paid an average of $44.40 for his BP shares, which is a 10.5% premium to the stock’s current price. At that level, Baupost is sitting on a yield-on-cost of 3.78%.

More Dividend Stocks Owned by Seth Klarman

At the end of June, Baupost also held shares of dividend-payers News Corp. (NWSA), Capital Source (CSE), PDL BioPharma (PDLI), BreitBurn Energy Partners (BBEP), and Ituran Location and Control (ITRN).

News Corp. was the firm’s second-largest stock holding overall (14% of equity portfolio), while Capital Source (2.8%), PDL (2.3%), BreitBurn (2.0%), and Ituran (0.99%) were all significantly smaller investments. All of these stocks are currently trading higher than Klarman’s average purchase price, with News. Corp (up 138%) and Capital Source (up 78%) leading the way. Baupost began accumulating both during the winter of 2008.