Summer Stroll #4 -- Why Do Stocks Go UP?

Did you ever wonder why stocks have risen over almost all of recorded history? You realize of course, if you can answer that question you will have the basis to answer the more important question -- where are stocks going from here? It turns out the answer is really quite simple. Stocks in the United States have risen because earnings and dividends have grown, and earnings and dividends have grown because the economy has grown. As you will see, the numbers are so similar we often wonder why we don't see more written about it in the popular media. As we said in our last edition, over the last 45 years, earnings and dividends have grown at 6.7% and 5.4%, respectively. Since 1960, Nominal Gross Domestic Product ( The measure of all goods and services produced in the US) has grown at 7.3% per annum. Nominal GDP is not a term you hear very often, but it is simply GDP not adjusted for inflation. Think about it. Stock prices are not adjusted for inflation, so to compare apples to apples we need the gross figures for economic growth and not the net figures. The GDP growth that we hear most often is in the range of 3%-4%, but that is after subtracting inflation. The US economy has actually grown at an annual rate of 7.3% for the last 45 years. Inflation, during this time, has averaged about 4.3%, leaving net GDP growth of about 3% on average for the period. What is the bottom line on all this data? As it relates to the Dow Jones Industrial Average, we believe it means that stock prices will continue to grow in the range of 6.5%-7%. Adding in the current dividend yield of 2.4% gives us a projected total rate of return over the next few years of 8.9%-9.4%. With 10 year Treasury bonds at 4.2%, stocks look awfully cheap to us.

Summer Stroll #3 -- Volatility Feels Like Risk

Please begin at the beginning of the Summer Stroll blogs to best understand this edition. The question always comes up, why dividends when Wall Street focuses on earnings and earnings are required to pay dividends? I always admit that earnings are, indeed, the most important ingredient to a successful investment, but earnings share a common trait with prices -- high volatility. As mentioned in the last piece, stock prices, exclusive of dividends, have grown at an annual rate of 6.7% over the last 45 years. During this same time earnings have grown at an average annual rate of 7%. Remember also that dividends have grown at 5.4%. Now, 7% sounds a whole lot closer to the 6.7% annual growth of price than the 5.4% growth of dividends, so again, why use dividends as the best indicator of true investment value? The title of this piece should give it away, volatility. Stock prices have an annual standard deviation of near 15%. That means that in a normal year we should expect stock prices to range from -8.3% (15%-6.7%) to +21.7% (6.7%+15%). This means that about 28% of the time we should expect stocks to fall, or about once every three to four years. There are all kinds of behavior studies that show that people are not very good losers. They wrongly conclude that things have changed and there will be no return to the three up years for every down year. I have managed money for a long time, and I can tell you this is absolutely true. People get crazy when they have a sizeable loss in their portfolio. But the reality of the situation is that losses are unavoidable. You must take the bad with the good, but you must have something to hang your hat on, other than prices, because prices will spook you on a fairly regular basis. And the bad news is, even though earnings have grown at about the same rate as prices, they are even more volatile. Earnings for the Dow Jones 30 have an annual standard deviation of near 22%. That means earnings in a normal year will be somewhere between -15.3% and +28.7%. Earnings simply do not help us make it through the bad years, they are more nerve wracking than prices. Now comes the lowly dividend. It has averaged 5.4% growth, but its standard deviation is only about 8%. Now we are talking. That means in a normal year we would expect dividends to produce between -2.6% and a +13.4%. It is the dividend's stability that gives it its power in predicting future stocks prices, as well as to help us to hang in there during the down years in price. Falling dividends represent only about a 16% probability, thus if you are watching dividends it is rare to have a bad year, so to speak. Now here is the important statistic to keep in mind. There is a 92% correlation between price and dividend. If we add interest rates, we can get the correlation up to almost 95%. We use the term: So goes the dividend, so goes the price. Dividends have the highest volatility adjusted correlation to price of any fundamental data, and that is the main reason we use them to determine "investment value." Couple this with the fact that dividends are real money and have represented 36% of the total annual return of stocks for the last 45 years, and we now have a powerful weapon with which to go hunting in the investment jungle. PS. I can't answer every question, but toss something out. It's a little quiet in here.

A Summer Stroll #2 -- The Story Begins

Note: To best understand this blog, please start at A Summer Stroll -- Part 1 The story of dividend investing is really a story within a story: the first is the series of events that led to my becoming a dividend investor and the second is what I have learned along the way. There has been much written about dividends in the past few years, including many academic studies, that show, conclusively, that dividends matter. I will cite a couple important studies later, but first let me share some of my own findings. I mainly use the Dow Jones 30 for my analysis because I have found that using this smaller group of companies, rather than the 500 in the S&P, has given me additional insight into what was driving my findings. Most academic and Wall Street research is done on the S&P 500. Please note when I change back and forth between the two. The data are very similar, but they do differ at times. In the 44 years from 1960 throughout the end of 2004, the total return of the Dow Jones 30 Industrials has averaged 10.4% annually, consisting of 6.7% price growth and 3.7% in dividend return. This means that nearly 36% of the total return of this important index has come from dividends. Many of you have read this statistic before, but you still see dividends as a bonus, rather than the powerful indicator of the true investment value that they are. Dividends have two qualities that put them in a class by themselves as far as offering a reliable long-term gauge of rate of return: they are real money( and it's real money we are after, not paper profits) and their growth trend is much more stable than earnings or sales, the most commonly followed corporate financial data. To start to visualize the power of the dividend as an indicator of total return, first consider that since 1960, dividend returns have ranged between 1.6% and 6.1%, a difference of only 4.5%, while price returns have ranged from -17.8% to 35.1%, a difference of 52.9%. At first these data do not appear to help us because, even though dividends have represented over a third of total return and are very stable, it is nearly impossible to estimate the future price return of the markets or a stock because prices are so volatile. The volatility of prices would seem to destroy any hope we have of estimating future total returns, and I will add, it is this volatility that damages investors' ability to stay the course in their investment strategies. Time and again, I see investors cut and run in periods of high volatility, and my heart sinks when they do. In my judgment there is no other passive investment on earth that rivals the wealth producing capacity of the stock markets, but this wealth-producing capacity comes with a price -- volatility. To find a way to see through volatility, as you will see later, became my quest during the crash of 1987. I will describe that story in a later edition of our walk. But here is where the second important quality of the dividend comes to the rescue -- its much lower volatility. Long-term dividend growth has been similar to long-term price growth, 5.4% to 6.7%. If we could prove that there is some correlation between long-term dividend growth and long-term price growth, we could use dividend growth as a less volatile proxy for price growth, and we would then have an instrument to cut throughout the fog of the day to day high volatility of stock prices and determine a "true" expected expected return from the markets or an individual stock. This is the search that I have been on for over 20 years. For my money, I have found the relationship that connects the two, and in doing so, as many of you know, I don't pay much attention to the day to day machinations of the stock market, however, come dividend time I am like a lion on the prowl. In the weeks ahead, I will share with you what I discovered that connects dividend growth with price growth and how we use it. I will also, hopefully, acquaint you with the term dividend total return, or dividend return as the primary was of valuing a security. Talk to you soon.

A Summer Stroll -- Part 1

Many of you reading this blog may already be dividend believers, and all I have to do is say dividend, and it has a fully formed meaning to you. I would be willing to guess that many of your fully formed good feelings about dividends are wrong. Others of you are absolutely clueless as to dividends having any value at all. You don't know that you are wrong, but you are. I think I know a lot about dividends, but I'm sure I'm off base in some areas, as well. I'd like to take a stroll this summer with any of you who want to come along and move beyond the concept of the dividend to the reality of what it means to invest, and what we mortals can expect. To do that I want to tell you a story. I will do it in small snippets, so I can be consistent and get us through this by the end of the summer. You may pass along this blogsite to anyone you like for our journey, and please do so. I find I understand what I know and believe, best, through other people's questions. I can't answer every question, but I'll try to give a general reply to areas of questions. This blogsite is an inhouse organ of a money management firm. It will be open only until the fall. After that we will close the door and only allow our clients and employees to view it. It is now open to the public to see how many people have an interest in dividends and are they digging deeply enough to find us. Within in the next few days, I will begin the walk. Get ready, I think you'll find it interesting.

Noise

Stocks fell by 420 points during a three-day rout last week. The question on a sunny Monday morning is: what's going on? But really isn't that the question that could be asked any day of any week, and 99% of the time the answer is -- nothing. It's just noise, or as academia says, randomness on display. There is no predictive power for the market's year ahead rate of return from the market's action last week and certainly none for the market's three year performance. Yet, the media will twist this around the neck of somebody or something until we are sick of it. If we want to deal with what is really going on we need look no farther than the dividend. Over the last 45 years, there has been a 92% correlation between the annual dividend of the DJIA and its price. If we add interest rates as a variable, there is almost a 95% correlation to price. Now, we are talking about something significant -- not noise or randomness. If we plug in today's dividend of $216, the historical correlation reveals the market should be trading at 11,099. If we add interest rates to the mix, the projection points to a 11,542. Either way, stocks are too cheap. The bottom line is with dividends for Dow Companies expected to rise 10% this year, and with our model saying the Dow is already 10%-15% under priced, the Dow, from a statistical perspective, now has less risk, not more as the pundits would have you believe.

Dividends on the Rise

Standard and Poors has just released their first quarter analysis of dividend actions by the 7000 companies in their universe. The number of companies increasing their dividends in the quarter grew by 16.9% over 2004 and 29.7% vs the same period in 2003. S&P believes the dividend increases will continue because of three forces: 1. very strong growth in cash flow, 2. dividends are now taxed like capital gains, and 3. the meandering stocks market. They make the point that the meandering stock market will likely prompt companies to show their shareholders the money in the form of dividends and rely less on share buy backs. S&P believes that dividends have returned to favor among investors much more than we do, but we agree with their assertion that in these wobbly stocks markets, cash dividends will catch the attention of more and more investors.

The Bank is Open to Those with an Open Mind.

I know all about the worries of our day--rising interest rates, inflation, falling dollar, balance of trade, deficits, and a stock market that can't seem to find its legs. But in the midst of the wall of worry, I think there is a simpler, better, and more meaningful message that investors should hear. Dividends are on the rise and dividends matter. I spend a lot of time making educated guesses about the future. For a change, I thought I would take a 20/20 look back. For the sake of discussion let's say ten years ago Wells Fargo, traded at $14 and paid a $.45 dividend, for a 3.2% dividend yield. Let's think the worst and assume that the wall of worry that was present in 1995 (the wall is always with us) was correct and WFC's stock price did not move a penny over the next 10 years. During this time, however, its dividend grew to $1.87, a 15.3% compounded annual rate. While the dividend growth is impressive, the rate of return for the period will still have to take into consideration that the price of the stock did not increase at all. In this hypothetical case, the annual internal rate of return for the period would have been 7.05%. That is acceptable, but not up to the 10%+ historic returns of the major stock averages. But consider for a moment the odds of WFC actually increasing their dividend over 15% per annum for a decade and the price NOT going up. It is impossible, because if it did it would be yielding over 13% on the original investment ($14/$1.87). Rising Dividend Investing is such a powerful idea because, dividends are vastly more predictable than stock prices. Yet, a consistently rising dividend will ultimately do what worry, wishes, and pipedreams can not--it will produce solid total rates of return and permit you to turn off CNBC and have a good night's sleep. Too many people are thrashing about in the dangerous waters of trading the news, when they could be sitting on a bank, literally.