Research

AN INTEREST IN DIVIDENDS

THE CASE FOR DIVIDENDS

“Do you know the only thing that gives me pleasure?” oil magnate John D. Rockefeller once asked, It is to see my dividends coming in. While no human has ever accumulated the wealth Rockefeller had by the early 20th Century, his notion on the importance of dividends are applicable to even the most novice investor today.  Income and cash flow remain critical to investors meeting their objectives, and in the current low-interest rate environment, investors are once again turning to dividends to assist them in reaching their goals.

The idea of shareholders receiving a cash distribution for their investment was one of the earliest innovations of financial markets.  Dividends first appeared in 1602 with the Dutch East India Company (DEIC).  The DEIC used a corporate charter to pool several projects rather than just one in order to avoid the risk of a single project tanking the whole company. After every project’s successful completion, the company returned cash to stakeholders in the form of dividends.  This advancement was so successful that it helped enable the company to become the world’s largest for over 200 years, and eventually led to the creation of the world’s first stock market.

In modern times, dividends have been a staple among 401k and retirement plans, high net worth individuals, foundations and endowments.   They provide the stability of periodic income, along with the ability to capture some gains from the stock market.  In this time of prolonged rock-bottom interest rates, dividend paying stocks are important as ever.

A well-known tenant of today’s investment professional world is that dividends can help drive the value of a stock.   While a common perception is that about half of a stock’s total return depends on dividend payments, the studies make for a more compelling case.  According to a study by Federated Investors using data from Yale professor Robert Schiller, over 90% of a stock’s total return directly depends on the dividend yield and dividend growth. 

As we wrote in our KnowRiskSM commentary for the 1st Quarter 2012, the record low yields from fixed income represent investors with an asymmetric risk/return profile; that is, investors face a potentially large downside to their investment with only a modest upside. We termed it Return Free Risk. Interest rates do not have much room to go lower, but rising rates could have devastating effects on an undiversified fixed income portfolio.  Dividend paying stocks help provide investors with income, while mitigating the interest rate risk that accompanies many fixed income investments, and provide the potential for growth.

Demand for fixed income instruments have driven interest rates so low that several companies now pay higher dividends on their stock than they pay interest on their bonds.  AT&T serves as an example. AT&T’s dividend yield at the end of 3rd Quarter 2012 was 4.67% while their 10 year bond with a coupon has a yield to maturity of only 2.29%.  Assuming that you receive the face value of the bond back at maturity, AT&T  makes all its interest payments and the company does not cut its dividend, AT&T’s stock would have to decline 23.1% in order for the bond to have a higher net payoff at maturity (see graph).  This same exercise can be repeated with several diversified dividend paying stocks like Intel, GE, Pfizer and others that offer a greater dividend yield than bond yield to maturity (see chart from Miller Howard Investments on the next page for 32 more companies).

Source: Bloomber Professional. Click image for full size.

In order to give some context to these figures, we graphed a chart of rolling 10-year price returns of the Dow Jones Industrial Average back to the 1930s.  As you can see, there have been only two instances since the Great Depression where the blue chip stocks have experienced price losses greater than -23.1% over a 10-year period.  The drawdowns did not go much beyond the -23.1% mark.  Given the historically low yields in the fixed income market, investors utilizing dividend-paying equity investments may help generate more attractive returns given the depth of correction that would have to occur for bonds to outperform. 

Source: Federal Reserve and DJIA data. Click image for full size.

Sample Companies with Higher Dividend Yield than Corporate Bond Yield to Maturity 

The list below shows a diversified list of 32 companies from one of our money managers where the dividend rates are higher than their bond interest.  Over the past year or so, the corporations on this list raised the dividend an average of 10.8% (excluding the CA outlier which would make it 21%).  Dividend growth, as we noted earlier, remains a large driver of returns.  Other money managers and indices have also focused on dividend growth. Standard and Poor’s, for instance, has an index called the S&P 500 Dividend Aristocrats which are large-cap US companies that have raised their corporate dividend every year for 25 years.

Source: Miller Howard Investments.

THE (VERY) LONG-TERM PICTURE

How does the current level of stock dividend yield compare historically? The chart below from Global Financial Data offers a bit of insight.  It compares the historical yield on a US 10-year Treasury Bond (blue) to the yield on the S&P 500 (red) which is estimated before the creation of the index.  While admittedly, this analysis is a bit different from the corporate bond analysis, it does offer worthwhile analysis. (Note: US Treasuries are theoretically termed risk-free while corporate bonds have credit risk among others detractors that would make them have a risk.  Not all stocks in the S&P 500 pay dividends)

Source: The Big Picture (ritholtz.com) and Global Financial Data.  Click image for full size.

Until the mid-1950s, stocks virtually always had higher dividends than US Bonds.  Presumably this was to incentivize investors into the more volatile asset class.  As capital markets developed in the later part of the 20th Century, however, bond yields consistently outpaced stock dividends.  Except for a brief period in 2008, this phenomenon held true until recently.  In other words, for one of the only times in more than 50 years, dividends are offering higher yields than government bonds.

THE FISCAL CLIFF – WILL THE ELECTION CHANGE ANYTHING? 

A topic of interest for all market participants involves the so-called fiscal cliff, referring to expiration of tax cuts and automatic reductions in federal government spending at the end of 2012 that could threaten an already weak domestic economy.  For dividend investors, the special 15% taxation treatment of dividends is set to expire at the end of this year.  Any analysis of whether this special rate will be renewed must be done in the context of the debate on the National Debt.  In 2011, the US Government’s deficit rose dangerously close to an artificially imposed debt ceiling.

With political parties in a deadlock, Congress managed to pass a short term measure to kick the can down the road to December 31, 2012.  This partisan deadlock greatly contributed to Standard and Poor’s decision to lower the US sovereign credit rating from the gilded AAA, and other credit rating agencies have repeatedly noted that the lack of a resolution from Washington threatens further downgrades.  At midnight on December 31 this year, several changes in taxation policy are set to expire as a result of short term policy extensions in 2011.  What affect will this have on dividends?

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The special tax benefit to dividends implemented by President Bush in 2003, and extended by President Obama in 2010, is also set to expire at the end of the year.  While this has the potential to affect the attractiveness of a dividend-based investment strategy, research on the subject paints a different picture.  Take for example, an analysis by Schaefer Cullen, Ned Davis and Tax Foundation.org which examined US equity returns for both dividend and non-dividend paying companies over various time periods at different tax rates.  Historically, dividend paying stocks have outperformed (sometimes by a considerable margin) their non-dividend paying counterparts in almost every period since 1972.

Given the uncertainty in Washington with the potential fiscal cliff and possible raising of taxes on dividend investors, it is important to consider performance of the stocks through various tax regimes.  Dividend stocks have offered more attractive returns through numerous environments and have also produced cash flow during that time regardless of tax rates.

GRIDLOCK IN WASHINGTON

Next month, Americans will head to the voting booth to register their choice for President of the United States as well as new Congress.  While the campaign season seems to be never-ending in recent years and voters once again are faced with the most important election in their lifetimes, many investors are more curious as to how elections and results may drive markets. Equitas is staying out of the political game and will leave the choice to the American populace, but an examination of the historical impact of elections on equity markets may prove beneficial.  As such, it may help planning purposes if the results could be estimated in advance.  Although there is no shortage of polls trying to guess the results of the upcoming election, many regard prediction markets (where participants can bet on the outcome of events like elections) as a way to follow the money on who is likely to be elected.  Even after a universally regarded lackluster performance in the first debate, as of October 9, 2012 InTrade, one these prediction markets, gives Barack Obama nearly a 63% chance of reelection (albeit after a big decline following the debate).

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While the Presidential race tightens, it is also important to look at the impact in Congress.  The opposite side of the aisle might find comfort in the prediction market’s odds of a Republicans controlling at least half of the legislature. As of October 9th 2012, InTrade put the odds over 88% of Republicans maintaining control of the House. 

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Regardless of one’s own political affiliation and beliefs, it may be more fruitful exercise to put these numbers in historical context.   The chart below from JP Morgan Asset Management, shows historical returns for different combinations of governing parties from 1937-2011.  In their findings, the most positive returns for the domestic equity markets occurred with a Republican President and Republican Congress (17.4%).  The second best time for market investors, however, occurred with a Democratic President and split Congress, returning 15.4% per annum.  Needless to say, the stock market is subject to greater factors than simple party designations, but it certainly is interesting to keep the historical returns in mind as the election approaches. 

Source: JPMorgan Asset Management. Click image for full size.

As the elections and fiscal cliff draw closer (accompanied by continued market volatility) it remains important for investors to be diligent in order to meet their long-term objectives.  Diversification across asset classes and geographies continues to be a good method to producing positive risk-adjusted returns through turbulent markets.  The dividend story extends beyond the United States as the chart on the next page from Federated notes.  With interest rates at current levels for fixed income assets, however, attractive opportunities may also be found in dividend-paying equity investments around the world.  In some cases, equity investments are yielding considerably more than their fixed income counterparts.  While dividend paying stocks are subject, of course, to market declines, they also may appreciate in value and raise dividend rates.  Conversely, with yields at current low levels, many fixed income investments are subject to duration (interest rate) risk which could lead to falls in the market value of the securities.  Again, with the uncertainty in the financial markets, dividend paying stocks may offer a solution to increase income and mitigate some of the interest rate risk and volatility in investors’ portfolios.

So now after a fifty year hiatus, stock dividends have returned to their historical position and are again yielding higher interest than government bonds.  With the potential for corporations to raise dividends over time, the opportunity is even more compelling.  As you know, after issuance, bond coupon rates do not get raised, and if anything, get refinanced to the lowest rate possible.

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Many types of investors need cash flow; foundations, endowments, insurance companies, and retirees.  It is nice to have another asset class, besides the traditional bonds, help to diversify risk and deliver needed cash flow to portfolios.  As you have read from our previous KnowRiskSM Commentaries, there are basically two risks for government bonds at this point.  One is that interest rates go up, and the other is that they don’t.