Wednesday, November 05, 2008
President-elect Obama has promised to roll back the Bush tax breaks on dividends and capital gains. Many people have asked me if such a change in taxation would change our favorable view of companies with consistently rising dividends. The answer is no. Many years ago I experienced a kind of eureka after an extensive look at 50 years of data for the Dow Jones Industrial Average (DJIA). I found that dividends and earnings were both highly correlated to price over this long expanse of time. But there was an important difference. Earnings had an annual standard deviation, think volatility, of nearly 23%, while dividends had a standard deviation of just over 8%. Indeed, I was surprised to find that DJIA earnings had a higher standard deviation than that of the Dow's price, which has been 14.5%. Annual dividends have fallen very few times over the last 50 years, while earnings have fallen about every 4 years. In short, I found that using dividends in combination with interest rates could produce a very tight fit between a prediction of the year-end price of the Dow and what actually happened. In our investment strategy, dividends represent not only a cash payment to us, which we prize, it also serves as a sort of tracer bullet to let us see the trajectory of the path of the market. The only change we may make in our clients' portfolios is that for clients in the top tax bracket we may suggest they switch to our Capital Builder investment style, which features lower dividend yielding stocks whose dividends are growing much faster than the average company. The overall performance difference between Capital Builder and Cornerstone (our higher yielding, lower dividend growth investment style) has been very small.