The Investment Constant
by James J Puplava CFP, President & CEO, PFS Group. April 8, 2005
Investment fads come and go. Every bull market has its favorites—the must have, can't lose, make a fortune companies that everyone must own. In the 1950s and 1960s it was electronics. In the 1970s it was conglomerates and "nifty fifty" stocks. In the 80's and 90's, it was consumer products, drug, and technology companies. Bull and bear markets alternate by trading places. This reminds us of Newton's third law— what goes up must come down. Today's winners could become tomorrow's losers. The one truism on Wall Street is that stock prices will fluctuate. They always have and they always will. Despite repeating market cycles, underlying principles of sound investment should not alter from decade to decade as Ben Graham was fond of saying.
Somewhere along the way we've transitioned from an investment-led market to a speculative-driven market. We have forgotten the habit of relating what is paid to what is being offered. Today most investors couldn't tell you why and what it is they own. The prevailing trend in the markets is to buy after something has gone up and sell after it has gone down without ever asking why. Buy and sell first— ask questions later. It is all part of the momentum game. Yet, like all mechanical approaches to the market, there are deficiencies. The black boxes don't tell you when the seasons have changed. It's only long afterward, when it is obvious, that the leaves have changed and the snow is falling.
Another truism about markets is that there will always be uncertainty. There is no "sure thing" and anyone that tells you differently is suffering from delusions. The markets over the last 100 years have demonstrated [even throughout all their vicissitudes— the unexpected and the unforeseen] that sound investment principles produced generally sound results. While you may not be able to count on the returns from stock appreciation, something more bankable is the returns you get from dividend payments. Dividends are the closest thing you get in the stock market to a "sure thing." They aren't guaranteed, but they are predictable. A company can always lower its dividend or in extreme cases omit it under financial difficulties. Nonetheless, most dividends arrive like clockwork every quarter. They are bankable and you don't have to sell a stock to receive the cash.
What's important to investors is that dividends offer several advantages. They enhance investors' returns over longer periods of time. Dividends make the difference between superior performances in both bull and bear markets. They can lower risk by creating greater stability in fluctuating markets, since dividend paying stocks hold up much better during periods of market uncertainty. They can also produce positive results when markets are unfavorable.
Dividend investing goes out of style when markets are going through a period of euphoria. They come back into favor after a decline. Following the stock market crash of 1929 dividend investing would remain in favor throughout the 40's, 50's, and 60's. Throughout this period investors bought stocks because of their dividends. Since stocks were considered to be a riskier class of investment, they offered investors higher returns. Most of those returns came through dividends. Investors wanted actual cash— not a future promise of higher earnings down the road. It would surprise most investors to learn that stock dividend yields were higher than bond yields throughout most of the last century. After the stock market crash in 1929, dividend yields rose to 10% and remained high and above bond yields until the 1960s. They rose again during the bear market of the 1970s.
It was only during the last bull market that stock yields fell below bond yields. A change in the capital gains tax in 1981 and a tax law change reducing the deductibility of CEO salaries altered the markets favoring capital gains versus dividends. A new tax law, "The Jobs and Growth Tax Relief Reconciliation Act of 2003," has once again altered the investment landscape. Dividends are now more favorably taxed. The new laws have lowered the taxable rate on income from most dividend stocks to 15%. There is a catch to this favorable tax treatment. Unless extended, the tax break ends at the end of 2008.
Long-Term Investment = Superior Terms
When the historical record is examined for investing in stocks, the attractiveness of dividends becomes more pronounced. In their landmark book "Triumph of the Optimists" authors Leroy Dimson, Paul Marsh & Mike Staunton show the terminal difference of reinvesting income to be monumental. Over a 101 year period, a portfolio of stocks compounded at an annual rate of 5.4%, handily beating the annual rate of inflation of 3.2%. The real return to investors was 2.1%. However, when dividends were reinvested, the annual return rises to 10.1%. This is significant when time is considered. In their study a $1 investment in stocks grew to $198 without dividends and $16,797 with dividends. The accretion in wealth was 85 times larger through reinvestment of dividends.
The authors found the impact of reinvested dividends to hold true in every equity market around the globe. Their conclusion: the longer the investment horizon, the more important dividends become in producing superior returns.
Jeremy Siegal came to the same conclusion in his new book "The Future for Investors." He warns that the reason most investors don't do well is that they overpay for stocks. Their enthusiasm for new fads or trends causes them to pay too high a price to get in on the action. He calls this fallacy of investing "The Growth Trap." "The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth— through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries-dooms investors to poor returns."  The biggest beneficiary of the latest technology is not individual investors. The biggest gains go to the entrepreneurs, the inventors, the venture capitalists, the investment bankers, and ultimately the consumer who buys a better product at a lower price.
A Case in Point
To illustrate this point Siegal compared the returns offered on two stocks: IBM and Standard Oil of New Jersey (now ExxonMobil). If you think of one invention that altered and drove our economy over the last half century, it would be computers. If you were fortunate enough to get in early on IBM, you would have expected to outperform an old economy stock such as Standard Oil. Siegal found just the opposite. From 1950 to 2003, the years of his study, IBM's growth was superior to that of Standard Oil in every way. Sales and earnings growth were higher as were dividends. The reason that Standard oil outperformed IBM was simple: overvaluation. You paid more to buy every a $1 of earnings in IBM. IBM's P/E multiple was more than twice that of Standard Oil. The dividend yield on Standard was also two-and-half times higher. This meant, as an investor, you were paid more every quarter and when you reinvested that dividend, you bought more stock. It cost you $13 to buy $1 of earnings in Standard Oil. By contrast, IBM investors had to pay nearly $27 for the same $1 of earnings.
|THE GROWTH TRAP|
|Growth Measures||IBM||ExxonMobil (Std. Oil NJ)|
|Revenue per Share||12.19%||8.04%|
|Dividends per Share||9.19%||7.11%|
|Earnings per Share||10.94%||7.47%|
|Avg Dividend Yield||2.18%||5.19%|
|$1,000 Investment (1950-2003)||$961,000||$1,260,000|
|Source: The Future for Investors by Jeremy Siegal|
As a result of higher dividends and a lower P/E multiple, an investor in Standard Oil as opposed to IBM was able to accumulate 5 times more stock. IBM investors were only able to increase their stock holdings three-fold through reinvestment versus a fifteen-fold increase in Standard Oil. This combination of higher dividends and a lower P/E multiple resulted in an increase in wealth of $299,000 or a 31% higher overall return.
In Siegel's judgment dividends and valuation are paramount in producing superior returns for investors. When investing over the long run, they become a critical factor. Dividends, in effect, become the wealth multiplier. In Siegel's own words, "The power of the basic principal of investor return is magnified when the stock pays a dividend." 
The Advantages of Constancy
If investors looked at the advantages of dividends, they would find them to be the one true investment constant of the stock market. They offer investors multiple benefits from income, the ability to compound returns and tax advantages to greater stability. The first advantage of dividends is that they provide a steady stream of income. This income is steady and dependable. Dividends on most stocks are paid every quarter. The income provides a return you can count on regardless of stock market conditions or price fluctuations. These dividends can also increase over time providing investors with a greater source of income and an inflation hedge. You don't get this with a bond. Bond values can erode with inflation, making the interest and principal worth less as a result of inflation.
Another advantage of dividend paying stocks is in addition to providing a steady stream of income, they also have historically produced higher total returns than non-dividend paying stocks. Dividend stocks have also been less volatile historically. They tend to fluctuate less and hold up much better in down markets. As shown in the graph below of Mergent's Dividend Achievers, superior dividend paying stocks have not only outperformed the S&P 500, but they have also fluctuated less in down markets. The reason is that dividends provide a cushion in times of market stress. In declining markets, investors gravitate to more defensive issues such as dividend payers in search of refuge in a storm.
Good Corporate Governance
In addition to income dividend paying, companies generally provide investors with better corporate governance. Once a company implements a dividend paying policy, they seldom abandon it. Dividend payments have to be included in cash flow and budget projections each year. Dividends more closely line up with company earnings and cash flow. Management is reluctant to pay out dividends— or increase them for that matter— if the earnings aren't there. At a time when corporate earnings have become suspect, dividends become a reliable safeguard against management abuse of shareholder capital. You either have the earnings or cash to pay the dividend or you don't. You can't pay out false earnings. Studies have consistently shown that there is a direct link between good corporate governance and control with dividend payouts.
Superior Dividend Paying Stocks
In his recent book, "The Future for Investors," Siegal found the best performing stocks were those with strong brand names in industries that provide a product or service that people need. They are companies that all have what Warren Buffett calls a big moat around them. In studying the S&P 500 over the last 53 years, Siegal found 20 superior companies in three kinds of industries: consumer staples, pharmaceuticals, and energy. These companies outperformed the S&P 500 in annual returns as shown below:
|ANNUAL EPS AVERAGE DIVIDEND|
|Average of Top 20||15.26%||9.70%||19.17%||3.40%|
|Source: The Future for Investors|
The fact that dividend paying stocks have outperformed the major indexes is a well kept secret. Study after study has shown the superior performance of dividend stocks. In a recent study conducted over a 31-year period, dividend paying companies outperformed non-dividend payers by 0.37% per month. Similar studies conducted in each decade over the last 30 years yielded similar results. Stock prices can fluctuate wildly over time. Dividends have demonstrated that they are the one true investment constant. Dividend returns are not only more consistent, but they also have become more reliable with time.
What makes a good dividend paying stock?
According to Mergent, superior dividend companies have several attributes in common. They are as follows:
- They are large and mature companies.
- They are past their growth phase with no major expenditures.
- They have strong cash flow and earnings growth.
- They have good management with solid corporate governance.
Most companies, when they first start up, need to conserve all the cash they earn from operations. This cash is used to build and expand the business. Once the business becomes mature and a brand name is established with a dependable customer base, they have less of a need for major capital expenditures, which consume earnings and cash. Mature and established companies have less of a need to come up with revolutionary new ideas or new products to stay profitable. Another aspect that makes companies good dividend payers is lower R&D requirements. If they do have to spend money, they have large operating margins, which support that R&D effort. Good examples are drug and healthcare companies.
You'll find that there is a common attribute to all of these companies. They tend to be in businesses that provide a product that people continually consume. They tend to have a strong brand franchise that engenders repeat business and customer loyalty. Because of this brand loyalty, they can charge more than their competitors. This is the reason they tend to enjoy higher profit margins on the things they sell. It is the higher profit margins that generate the cash that pays the dividends. Moreover, since they provide a product that people need and consume, customers keep buying their product, which means more growth in sales and earnings.
When analyzing a dividend paying stock, there are several ratios that analysts use to evaluate a dividend candidate. They are listed in Basic Financial Metrics & Ratios. These ratios are not all inclusive, but the investor will find them helpful in evaluating a prospective company. They are a place to start. Most of the information that an investor needs can be found in a Value Line Investment Survey or on the Internet at such sites as Yahoo Finance, EDGAR Online, or 10K Wizard. There are also many excellent books out on the subject that investors can learn much from. I've listed a few in the footnotes.
A Sound Strategy
Markets change over time. Stock prices will continue to fluctuate, but sound investment strategies never lose their relevance. The one investment constant that keeps showing up in study after study of investment markets and investment returns is the importance of dividends and the role they play in compounding wealth. When we forget this investment constant we become most vulnerable to the vagaries of the investment markets. At a time when so much uncertainty abounds, returning to the basics of sound investing means taking a serious look at dividend paying stocks. Markets may forget them, but they don't forget investors. Dividend paying stocks provide a steady and dependable return in rising or falling markets.
Finally, we are at a stage in our country's development— as are European countries and Japan— where populations are ageing. Aging populations have a greater demand for income. What we know about planning for retirement is that people are living longer and must deal with ever-rising living costs due to inflation. As long as we have governments that spend more than they receive in taxes and as long as money has no anchor such as gold, another investment constant is inflation. Inflation is a fact of life that investors should become more mindful of in an age of fiat currencies. If you are planning for retirement today, compounding your wealth takes on more importance. In the future you may have to depend more on what you have saved as governments increasingly come under duress due to ageing populations. Social security is in trouble as is Medicare. This means investors can look at lower benefits, means testing, later qualifying dates, and less income from government-type pensions due to inflation. This, dear investor, means you will have to rely more on yourself, if you are ever to become financially secure. The more that you can save; the more you can compound your wealth, the more you will have when you retire. Dividend investing is ideally suited to accomplish both objectives.
|Archer-Daniels Midland||$ 36||$154||$245|
|Johnson & Johnson||$244||$480||$960|
|Procter & Gamble||$216||$397||$647|
|Tootsie Roll||$ 54||$154||$207|
|$10,000 Investment Each Company, Financialsense.com Source: Value Line & Bloomberg|
To illustrate this point, I've taken $100,000 and divided it equally among 10 high-dividend achiever stocks. All of these companies provide either essential services or manufacture a product that we consume. Going back 10 years, I show the income that would have been received from this portfolio at the time of origin and over a ten year period. As this real example demonstrates, income would have gone up each and every year. In addition to increasing dividends, the portfolio also appreciated over time. The original investment of $100,000 would be worth over $326,000 today. During that ten-year period, the annual dividends would have completely recouped the original investment. Had an investor reinvested those dividends, he or she would have become a millionaire. No more needs to be said. To create real wealth, you need to compound your investments. There is no better way to do that than through dividend investing.
 Siegel, Jeremy J., The Future For Investors: Why the Tried and True Triumph Over Bold and New, Crown Business, 2005, p.3.
 Ibid, p.44.
 O'Shea, Peter & Worrall, Jonathon, Beating the S&P with Dividends: How to Build a Portfolio on Dividend Paying Stocks, by Peter O'Shea & Jonathan Worrall, John Wiley & Sons, 2005, p.42.
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