Most of the companies in Table 10.1 had average dividend yields that were near or above the yield of the S&P 500. Only two, Pfizer and Merck, had yields more than one percentage point below the index. And five companies—Royal Dutch, Philip Morris, Wrigley, Crane, and Hershey Foods—put to rest the notion that companies cannot have high dividend yields and maintain strong growth. All five of these companies delivered both higher dividend yields and earnings growth than the S&P 500.
High Dividend Yield Investment Strategies
Strategies of investing in high-yielding stocks are not new. The “Dow 10” or “Dogs of the Dow” has been regarded as one of the most successful investment strategies of all time.5
The strategy calls for investors to buy the ten highest-yielding stocks of the thirty firms in the Dow Jones Industrial Average (the Dow 30) at the end of each year. Since management usually tries to maintain their dividend payouts during times of adversity, stocks with a high dividend yield are often those that have fallen in price and are out of favor with investors. For this reason the Dow 10 strategy is often called the “Dogs of the Dow.”
Figure 10.3 shows the cumulative returns in various dividend strategies compared to their benchmarks. Since the S&P 500 Index was founded, the Dow Jones Industrial Average has actually outperformed the index, providing investors an average annual return of 12.00 percent versus 11.18 percent for the S&P.
But the return of the Dow 10 strategy is much better than the Dow industrials (the Dow 30), providing investors with a 14.43 percent return, about 2.5 percent per year higher than the Dow 30 and accumulating to $493,216, about two and a half times that in the Dow 30.
The Dow 10 high-dividend strategy works well during bear markets, confirming that dividends serve as a bear market protector. In the 1973–74 bear market, when the Dow 30 was down by 26.4 percent and the S&P 500 Index was down 37.2 percent, the Dow 10 high-yield strategy actually gained 1.4 percent! Similarly, in 2001 and 2002, the Dow 30 was down 20.4 percent and the S&P 500 Index was down 30.2 percent, but the Dow 10 fell only 9.9 percent. Clearly dividends cushioned the declines in the market, a feature that should be comforting to investors.
TABLE 10.1: DIVIDEND YIELD ON TOP-TWENTY SURVIVOR FIRMS
FIGURE 10.3: HIGH-YIELD DIVIDEND STRATEGIES
The S&P 10
A natural extension of the Dow 10 is to apply the high-dividend strategy to another group of large stocks, such as the 100 largest firms in the S&P 500 Index. After all, why should the strategy of choosing the ten best-yielding stocks be limited to the Dow industrials, which are only one quarter of the total market value of stocks?
Indeed, we find that choosing the ten highest-yielding stocks among the largest 100 S&P 500 stocks does even better than the Dow 10. These accumulations are also shown in Figure 10.3. A thousand dollars invested in these high yielders from the S&P 500 Index at the end of 1957 accumulates to more than $811,000 and beats the Dow 10 by more than 1 percent per year.
As with the Dow 10 strategy, the S&P 10 again demonstrates that dividends are a bear market protector. From 1998 through 2002, the largest 100 stocks in the S&P 500 were down a cumulative 20 percent. But the S&P 10 actually rose 13 percent over that same period. During the 1973–74 bear market, when the largest 100 stocks were also down 20 percent, the S&P 10 held steady and even gained 6 percent.
The Core 10
But there may be an even better high-yield strategy than the Dow 10 or S&P 10. Many investors, especially those with a long-term perspective, prefer to receive a steadily growing rather than fluctuating level of dividends. A policy of continually raising the dividend commits management to meet specific return requirements of its shareholders.
For this reason, we have also examined the ten highest-yielding stocks among those that have not reduced their dividend in the last fifteen years. A period of fifteen years was chosen because that means the firm must have passed through at least one recession. Managements that have not cut their dividend have demonstrated the consistent earning power and strength of their corporations. I call this strategy the Core 10 because management’s commitment to dividends is seen as a basic or core strategy.
In Figure 10.3 we plot the accumulation of wealth by pursuing the Core 10 strategy in both the Dow industrials and among the top 100 market-value stocks in the S&P 500 Index. The Dow Core 10 does indeed outperform the Dow 10 by about 0.60 percentage point a year. Furthermore, the Dow Core 10 strategy permits a 20 percent reduction in the turnover of firms at year’s end, which reduces both capital gains realization and transaction costs. The S&P Core 10 strategy reduces turnover, but performs about the same as the S&P 10.
Calibrating the Return Accelerator
Dividend-paying stocks do well through market cycles, since investors who reinvest dividends accumulate more shares during bear markets. Table 10.2 shows how many years it takes after a stock declines for investors to achieve the same return they would have received had the stock price not declined. These tables assume the firm maintains its dividend. The investor recoups the price loss because the lower price allows dividend-reinvesting investors to accumulate more shares than they would have accumulated had the stock never declined. The value of these extra shares eventually surpasses the magnitude of the price decline, making the investors better off.
As can be seen, the greater the dividend yield, the shorter the time needed for investors to recover their losses. Surprisingly, the table also shows that the greater the decline in price, the shorter the period of time needed to break even, since reinvested dividends accumulate at an even faster rate.
For example, take a stock that starts with a 5 percent dividend yield. If the stock then declined by 50 percent and stayed down, investors who reinvest dividends will recover their loss in 14.9 years. This is because they would have doubled the number of shares they hold, compensating for the decline in the price.
A similar story held for Philip Morris. At the end of 1991, Philip Morris’s dividend yield was only 2.8 percent. But with steadily rising dividends and falling prices, its dividend yield rose throughout the decade and surpassed 7 percent in 2000. The extra shares accumulated at these high dividend yields were the major reason the return on Philip Morris’s stock return stayed high, despite its poor performance during the 1990s.
Table 10.3 illustrates the return accelerator. It shows the return investors would earn if the price of the stock returns to its original level after the number of years indicated in Table 10.2. We noted above that if a stock had a 5 percent dividend yield and declined by 50 percent, it would achieve the same return in 14.9 years as a stock that had not declined at all. If after 14.9 years, the stock that fell 50 percent recovers to its original price, the annual return on the stock over those 14.9 years would rise to 15.24 percent, a return that is 50 percent greater than what the stock would have been had the stock not fallen in price.
TABLE 10.2: YEARS TO BREAK EVEN AFTER PRICE DECLINES
The return accelerator worked for Philip Morris when the stock staged a recovery in late 2003. Many other tobacco stocks, such as R.J. Reynolds and BAT Industries (formerly British-American Tobacco), experienced similar return accelerations when their prices recovered. Had these firms not paid dividends, their returns would have been far lower.
Share Repurchases
In recent years firms have used retained earnings to buy their shares in the open market rather than paying dividends. As noted earlier, despite recent legislation that reduced tax on dividend income to the same level as capital gains, share repurchase is still a superior way of delivering returns to shareholders in the most tax-efficient way. Using earnings to buy shares instead of paying dividends results in higher share prices, but these higher share prices are not taxed until the shares are sold. As a result, investors can defer the tax on the shares and may escape the tax completely if they are included in a non-taxable estate.
TABLE 10.3: ANNUAL RETURN WHEN PRICE RECOVERS
If a firm repurchases the same dollar amount
of shares as it pays as dividends, both the bear market protector and return accelerator will work. If the price of the stock goes down, the number of shares repurchased rises over time. This reduces the number of shares outstanding and raises both earnings per share and the share price. In the case of dividend reinvestment, the investor gains by accumulating more shares. When share repurchase takes place, the per-share earnings of the firm will rise and boost the price of the stock. In either case, the figures shown in Tables 10.2 and 10.3 will hold.
It appears that share repurchases accomplish the same wonderful results as dividend reinvestment with the extra bonus of receiving tax-deferred capital gains. But this is often not the case. In practice, it has been shown that management is not as committed to a policy of repurchasing shares as it is to paying dividends.6 Once a cash dividend level is established, management is often reluctant to lower its level. Reducing the dividend is universally regarded as a bad signal from the firm, and the market often takes the shares down sharply when a reduction is announced.
In contrast, share repurchases often occur in a haphazard fashion. It is true that the price of a stock often responds favorably when management pledges that it will repurchase shares, but shareholders have a harder time monitoring whether management in fact is fulfilling its pledge. Various studies have concluded that a large percentage of announced share repurchases are not completed.7 Often management finds other uses for earnings and not all of them are in the interest of shareholders.
So although from a theoretical standpoint share repurchase will result in an identical pattern of returns as dividend reinvestment, in reality share repurchases have rarely served as a steady source of shareholder return. It is more reliable to have the investor purchase her own shares with the dividends that management returns to the shareholders than for management to serve as a stand-in for the investment that shareholders can do on their own.
Dollar Cost Averaging
Some sharp readers may have noted that the return-boosting qualities of dividend reinvestment are similar to what occurs when investors undertake a dollar cost averaging investment strategy. Dollar cost averaging involves the investment of a given stake in the market over regular intervals of time. Like dividend reinvestment, dollar cost averaging takes advantage of the fact that when prices are lower and prospective returns are higher, more shares are purchased. Similarly, when prices are higher and prospective returns are lower, fewer shares are purchased.
Can dollar cost averaging substitute for dividend reinvestment? The answer is yes if the firm is a long-term survivor. If the firm is not, then buying an increasing number of shares as the price sinks will be a losing proposition. Firms that have not cut their dividend tend to be long-term survivors and are therefore well suited for the strategy discussed here. The more speculative the stock, the less likely it is to be a survivor and the less likely it is that dollar cost averaging will lead to superior returns.
Other Cash-Generating Investments
The bear market protector and return accelerator work not only for stocks that pay a high dividend. They will also work with any investment that provides investors a large cash return. Other high-yielding investments, such as certain real estate investment trusts (REITs) or high-yielding (junk) bonds, qualify.
REITs are corporations whose income is derived from the ownership of real estate assets. REITs have special tax characteristics. If they pay out at least 90 percent of their income in the form of dividends to their shareholders, then the trusts are themselves exempt from corporate income taxes.8 The average dividend yield from 1996 through 2003 for REITs has been 6.6 percent, more than four times that of the S&P 500 over that same period.
Junk bonds are bonds issued by corporations whose credit standing is below investment grade. These bonds carry substantially higher interest rates than bonds of investment-grade corporations or most government bonds.
The reinvestment of dividends from REITs or the reinvestment of interest payments from junk bonds also makes those assets bear market protectors and return accelerators. During every recession, prices on junk bonds fall as the risk that a corporation will default rises. Yet investors who are reinvesting their interest income will purchase more bonds, so when interest rates ease and the spread between risky and safe bonds falls, the return accelerator works wonders.
REITs offered particularly high yields when they fell out of favor during the late 1990s during the boom in technology stocks. When they regained popularity, the extra shares invested boosted the returns on REITs, so from the mid-1990s through 2003 they had one of the highest returns of any asset class.
Summary
Over the past decade dividends have received short shrift as investors sought capital gains. But examining the history of stock returns reveals the importance of cash dividends. Dividends not only protect investors in bear markets but have boosted returns significantly when the market rebounds.
Virtually all the best-performing stocks from the original 1957 S&P 500 pay dividends, and most have a dividend yield above the average.
The returns on many stocks, such as the tobacco manufacturers, have benefited greatly from cash dividends despite the fact that litigation risk has depressed the price of these stocks. Reinvestment of dividends has also helped the energy sector. The next chapter examines the source of dividends and earnings, and discusses how to measure them.
CHAPTER ELEVEN
Earnings:
THE BASIC SOURCE OF SHAREHOLDER RETURNS
In recent years, substantial capital arguably was wasted on a number of enterprises whose prospects appeared more promising than they turned out to be … [The] amount of waste becomes unnecessarily large when the earnings reports that help investors allocate investment are inaccurate.
—Alan Greenspan, 2002
The stock market had waited for this announcement with great anticipation. At 4:15 p.m., fifteen minutes after the market closed, Intel, the world’s largest manufacturer of microprocessors, would report its quarterly earnings. Wall Street traders and analysts watched Intel’s numbers like hawks. The firm was considered a bellwether not only for the technology sector but for the entire economy.
The announcement flashed across the screen: operating earnings came in at 47 cents a share, 5 cents above expectations, but those earnings excluded acquisition-related expenses, one-time charges for purchased R&D, and the amortization of goodwill. Reported earnings, or net income, the official earnings figure sanctioned by the Financial Accounting Standards Board (FASB), was actually much lower than expected.
But the market cared little about the official figure and focused on operating earnings because that is the number that analysts and Wall Street forecast. In response to the better-than-expected operating earnings, the price of Intel’s shares surged in after-hours trading.
What is going on here? Why is the market ignoring official earnings and looking instead at an earnings figure that is neither defined nor sanctioned by the FASB? More important, what earnings measure should investors use to estimate the profitability of a firm?
Measurement of Earnings
Everyone who is into stocks talks about earnings because everyone knows that earnings drive stock prices. But when economists or analysts start discussing the details of these earnings, most investors’ eyes begin to glaze over. Descriptions of deferred expenses, restructuring charges, pro forma earnings, pension costs, or accounting for employee stock options either bring up bad memories of a college accounting course or seem too complicated to be worth figuring out. For that reason I would not blame any reader who wants to jump to the next chapter to learn about the future of our economy and financial markets. But if you will take a few minutes to read this chapter, you will find some very worthwhile information that not only helps you pick stocks but also understand some critical issues impacting public policy and your pocketbook.
One of these issues, whether employee stock options should be expensed, has even moved into the political arena and s
parked heated debate in the U.S. Senate. Technology firms have organized public demonstrations claiming that their workers would lose the very incentives that are critical to maintaining U.S. leadership in technology if these FASB proposals go through.
Another issue, how firms treat pension costs, is critical to whether pension benefits that corporations have promised to their retired workers will actually materialize. News reports are filled with the huge deficit of the Pension Benefit Guaranty Corporation, a government-sponsored enterprise that insures the pension of 55 million workers. Some fear that looming pension defaults could turn into another savings-and-loan fiasco, costing taxpayers hundreds of billions of dollars.
Are Current Earnings Real?
Robert Arnott, editor of the Financial Analyst Journal, clearly believes that corporate America’s profit numbers are deceptive. In a debate with me in 2004, he said:
I believe current reported earnings have a lot of fluff. [If we use proper accounting for pension funds] there goes between 15 percent and 20 percent of S&P earnings. If management stock options are fully expensed, there goes another 10 percent to 15 percent of S&P earnings. So I would argue that 25 percent or thereabouts of S&P earnings are fictitious.1
The Future for Investors Page 16
