Tuesday, July 10, 2007
The question always comes up, why focus on dividends when Wall Street lives and dies by earnings, and earnings are required to pay dividends? I always admit that earnings are, indeed, theoretically more important than dividends, but earnings share a common trait with stock prices -- high volatility--that diminishes their ability to predict value. Stock prices for the Dow Jones Industrial Average (DJIA), exclusive of dividends, have grown at an annual rate over the last 50 years of 6.7%. During this same time, earnings have grown at an average annual rate of 7.0% and dividends have grown at 5.7%. I admit that the DJIA’s earnings growth of 7% sounds a whole lot closer to it price growth of 6.7% than the 5.7% growth of dividends, so again, why do we say that dividends are the best indicator of true investment value? Volatility, dear reader, volatility and predictability. Since 1957, the DJIA’s price has had an annual standard deviation of near 15%. That means in a normal year, we should expect stock prices to range from -8.3% (6.7%-15%) to +21.7% (6.7%+15%). Thus, it is normal for stock prices to have a down year; about one in three is the historical average. Here’s how dividends win out over earnings in predicting the long-term intrinsic value of the DJIA. While earnings have grown at almost the same rate as stock prices (7% vs. 6.7%), they have been even more volatile than prices. Operating earnings for the DJIA, as calculated by Value Line, have had an annual standard deviation of near 22% over the last 50 years. That means that earnings in a normal year will be somewhere between -15% and +29%, an even wider path of distribution than that of the DJIA’s price. In essence, I think the record shows that earnings’ ability to predict stock prices is not as big a deal as Wall Street makes of it. Indeed, earnings are even more suspect when considering the fact that Wall Street is not very good at predicting earnings in the coming year. Now comes the lowly dividend. Over the last 50 years, dividend growth for the DJIA has averaged 5.7%, but its standard deviation is only about 8%, about half that of DJIA prices, and two-thirds less than earnings. Now we are talking. In addition, during this time, DJIA annual dividends have fallen only 7 times, compared to earnings, which have fallen 14 times. Finally, because dividends are real money returned to shareholders, they have the additional quality of representing nearly 37% of the total return of the DJIA over the long-term. It is the dividend's stability that gives it its power in aiding us in predicting future stocks prices, as well as, to help us to hang in there during the down years. With the recent uptick in interest rates, our fair value model for the DJIA is now 13,800. Interest rates can spoil a summer or even a year, but in the long-run, my work shows that interest rates are not the deal maker. Dividends do best at that role, and as long as dividends are growing faster than roughly 6% (10% this year), I believe stocks are headed higher.