To many people, we are known as "The Dividend Guys." To those who know us best, we're known as the "Rising Dividend Guys." We were given those nicknames because we have been running our Rising Dividend strategy for nearly 20 years and now have nearly $600 million invested almost exclusively in dividend-paying stocks. The world, economy, and securities markets have seen a lot of changes over the past 20 years. We imagine some folks are wondering why we haven't changed our strategy along with them. They may wonder if we are a "one trick pony".
We'll get back to that question in Part II of this article. For now, it might be helpful to recount how we became the Rising Dividend Guys in the first place.
Our "Eureka Moment"
When we first began investing in dividend-paying companies, it was not because we understood the value of dividends. At the time, we employed a pure earnings-growth investment strategy and paid almost no attention to dividends. We became dividend investors because after the stock market crash of 1987, one of our clients added substantial new assets to his accounts with the stipulation that we invest the money only in dividend-paying stocks.
The client had been with us for many years and was one of our biggest supporters. However, up to that point our work for him had been almost exclusively in municipal bonds. Those were the days of double-digit interest rates in all types of bonds, and many of our clients had a greater percentage of their assets in bonds than stocks. In addition, dividend yields, while much higher than today, were still lower than most bond yields; thus, dividend-paying stocks were not in high demand and received little attention in the media.
The client gave us the statement from the brokerage firm that held the assets he was transferring and asked that we study the holdings and make recommendations for changes. He admitted that he did not think the portfolio had done very well over the last five years, and that was one of the reasons he was transferring it to us.
Although we didn't know it at the time, studying the holdings in that portfolio would change the way we understood investing forever. At first glance, the portfolios looked like they held a bunch of dogs: slow growth or no growth companies. The portfolio was full of utility, energy, and basic industry stocks whose prices had moved up only modestly over the preceding five years compared to the major stock market indices.
As we studied the portfolio, we experienced what we have described over the years as a eureka moment. While the price appreciation for most of the stocks in the portfolio had performed poorly versus the S&P 500, 22 of the 25 stocks in the portfolio had equaled or outperformed the overall market when we added the dividends that each company paid.
The only reason we even saw the total returns for the stocks was because we were using the Value Line Investment Survey to research the companies, and the total return for each stock was prominently displayed in the data. Normally, we focused primarily on past and future earnings growth when researching companies, and compared the predicted 3-5 year earnings growth to the price-to-earnings ratio to offer a kind of valuation metric.
"Son, Never Invest In A Stock That Doesn't Pay A Dividend."
Seeing that company after company in this portfolio of high-dividend yielding, slow growth companies had equaled or outperformed the Dow Jones Industrial Average (DJIA) on a total return basis was not only surprising; it was also arresting. It made us stop in our tracks and try to understand how this phenomenon could have happened, and we be unaware of it.
After several days of research, we found that dividend yields of both the utilities and the energy stocks were highly correlated (nearly 90% in some cases) with long-term interest rates. Since interest rates had fallen sharply over the previous five years, almost all of the stocks in these two sectors had risen in price by approximately the amount of the fall in rates plus one other important consideration. The second consideration was that most of the companies in the portfolio had raised their dividends nearly every year. On average, the combination of these two factors had caused the price of the Dow Jones Utility Average (DJUA) to rise by about 7.5% annually from November 1982 through November 1987. Excluding dividends, this did not compare well with the 11.7% annual price appreciation of the DJIA during that time.
The shortfall disappeared; however, when we added the dividends. The average dividend yield of the DJIA for the period was near five percent, while the average yield of the DJUA was near nine percent. Including dividends, the DJIA had produced a total return of just over 16.7% compared to the DJUA's 16.5%. It took several days for us to get our heads around the fact that the slow-poke utilities had performed as well as the faster growing industrials in one of the strongest performing five-year periods in stock market history.
Total Return Analysis
November 1982- November 1987
Average Dividend Yield
Dow Jones Industrials
Even more surprising was the client's reaction when we told him his portfolio had not underperformed the market as he had thought. He was in as much disbelief as we were when he first saw the results. He then made a very poignant statement. He said, "My father lost everything in the crash of 1929. He was never the same after that happened. In one of the only times I ever talked with him about what happened, he told me, 'Son, never invest in a stock that doesn't pay a dividend. Looking back, dividend-paying stocks were the ones that performed the best during the Depression.'"
Our client went on to explain that it was easy to see that his dividend-paying stocks held up better than the overall market in bear markets, but he was completely surprised that they had also done as well in a roaring bull market.
Even though the portfolio had performed better than he had thought, he stuck with his plan to move the assets over to our management, thus, we became dividend investors in late 1987. It was not until 1989, however, that we officially began offering a dividend investment strategy. During those two years, we looked at dividends in every way we could think of trying to build an investment strategy that we both understood and believed in.
In the remainder of this letter we will explain what our research has revealed about rising dividend investing. Some of it we learned in those early years; some we are still learning. We will share two sets of ABCs that form the basis of why we gradually became pure rising dividend investors. It will also serve to explain how we are structuring your portfolios for what we see unfolding in the stock and bond markets today.
The First ABC's:
Earlier we spoke of the eureka moment when we realized how important dividends were to the total return of most stocks. Based on the first discovery, we uncovered a secret about dividends that we believe few investors are aware of even today, when dividend investing has become very popular.
In researching the DJIA for the period between 1960 and 1989, we found that dividends had produced nearly 40% of the index's average annual return. For this 29-year period, annual price growth of the index was approximately 5.0%, and dividend yields averaged 4.3% for a total average annual return of 9.3%. (A recent study reveals that dividends have made up 54% of total returns from 1930 to the present.)
We also found that annual dividend growth of the DJIA for the period was 5.5%, again very close to the annual price growth of price of 5.0%.
Our final discovery during the early years of our research was how predictable dividends were in comparison to earnings and prices. This discovery may not seem as profound as the first two, but it has given us the third leg of the stool on which our entire dividend investing strategy rests. The standard deviation in DJIA dividends had only been 8.8%, whereas earnings and prices had average annual variances of 20% and 14.6%, respectively. The table below is a summary of our findings.
To appreciate why this first set of ABCs was so important to our original understanding of the relationship between dividend growth and price growth, let us take you through a short mental checklist.
The data for the period and other statistical tests we made showed that in the long run stock prices were more highly correlated to dividends than earnings. Importantly, the annual variation in dividend growth was far lower than that of earnings. Remarkably, dividends rose in 24 of the 29 years we studied. Stock prices, on the other hand, fell on an annual basis in about a third of the years.
Why Dividends Are the Best Predictor of Value
As we mulled over these findings, we arrived at a conclusion that we still hold today. Stock prices are inherently volatile because they attempt to predict the future value of a company. Since the future is unknown, investors are forced to constantly recalibrate their valuation calculations as new facts become known (or new rumors are circulated). It is just inherent human fallibility that many people do not rightly judge this never-ending flow of new information. Many of these people will overreact negatively or positively based on their faulty reading of the situation and push a stock too high or too low.
Corporate earnings are beset not only with the same unknowns about the future as are stock prices, but also have the added burden of being confusing. Our Bloomberg terminal currently offers eight different ways to look at a company's earnings. The Generally Accepted Accounting Principles (GAAP) method of reporting, which emerged after the Tech bubble, has gradually lost favor, even though it is supposed to be the standard. The most widely used measure of earnings is now nicknamed Comparable and Adjusted.
You can tell by the name that there is significant financial engineering involved in this method of determining earnings. Worse yet, "actual" earnings can change. The accounting profession calls it "restating" past earnings. We call it the "Oops!" process.
We believe the dividend is the best indicator of value because dividend payments are made in cash. Cash is cash and once paid cannot be later changed or taken back, as earnings can. In addition, cash dividend payments are not derived through financial engineering, but are set by the people who should know a company best -- the board of directors.
Because of this, we have long believed that dividend declarations by companies not only say something about their past performance, but also offer a hint about their future. This is because in the United States a corporation's stock price is severely punished when dividends are cut. We believe this causes a natural tension in which most boards of directors set dividends in the sweet spot that is a mix of a reward for the past year, as well as their best guess of how much they can afford to pay next year, come heck or high water.
If we were to reduce everything we have said so far into one sentence, it would be this:
The total return of a stock over a five to ten year period will likely be close to the sum of its current dividend yield plus its projected dividend growth, adjusted slightly by changes in interest rates.
In ABC's Part II we will share some tactical maneuvering we have found is important in investing in dividend-paying stocks. The bottom line for Part I is that, in the long run, the market is willing to pay for dividend yield and dividend growth almost equally. Indeed, we have found this true for almost all markets anywhere in the world. Interestingly, in periods of rising interest rates such as we are experiencing now, investors have been willing to pay more for dividend growth than dividend yield. In falling interest environments, just the opposite has been true.
The key words, as they relate to dividend growth, are consistent and persistent. One hit wonders need not apply for price appreciation. The market ignores dividend manipulation better than most people realize. Investors are gradually won over by dividend actions that reflects the trend of business results and the future prospects for companies.
Next time: Part II of The ABC's of Dividend Investing.
Disclosure: I have no positions in any stocks mentioned.
Additional disclosure: All of us at DCM and our clients are fully invested in dividend-paying stocks.