Deceptively Simple

 

It is not hard to find companies that make money, year after year. Collectively, the companies in the S&P 500 have made money every year over the 40 years through 2009. It is not hard, either, to find companies that grow their earnings. The companies in the S&P 500 have increased earnings in all but 11 of those 40 years.

 

One would think that such consistent earnings and earnings growth would inspire similarly stable and generally growing share prices; but, they have not. In fact, share prices often move in opposite directions from companies’ earnings. During the most recent quarter, for example, the S&P 500 was down 11.9%, even as its companies were reporting and forecasting attractive earnings growth.

 

Most often, such share price performance is merely chalked up to “volatility.” But, why are share prices so much more volatile than the companies’ earnings that ultimately define them? And, do the causes of that higher volatility create more risk or more opportunity for investors?

 

 

A century ago, the stock market was less volatile because its stock prices were more closely tied to companies’ book values and its stock price movements more closely tied to companies’ current earnings. If companies made money and retained it (thus, adding to book values), share prices would go up; if not, share prices would stay the same, or go down.

 

As such, investors were indifferent to dividend policy; share prices increased (or decreased) by the amount of companies’ current earnings, less dividends paid out. Investors’ total returns, therefore, would be the same as the earnings growth rates of the companies they owned.

 

In the early 1900s, however, Goldman Sachs redefined the stock market’s pricing mechanisms and, thus, changed that tight connection between earnings and investors’ returns.

 

According to prominent biographer Charles Ellis, Henry Goldman (son of the firm’s founder) convinced investors that book value pricing failed to adequately recognize companies’ “earnings power.” The better method, he argued, was to capitalize companies’ expected earnings; that is, to multiply expected earnings by arbitrarily-established price/earnings ratios to determine share prices.

 

In concept, it was a more accurate valuation method; stocks were priced in relation to their future prospects, not their past performance. They also became sensitive to investors’ changing emotions and return expectations.

 

In practice, however, capitalizing expected earnings reduced investors’ connection to companies’ current earnings; capital gains were made only if earnings grew and/or if price/earnings ratios increased. Just delivering the same level of earnings was not highly valued. No wonder share price movements seemed to have little connection with current earnings; they were not supposed to.

 

 

Henry Goldman did not promote this change so that investors would be frustrated when market prices moved independently from companies’ earnings. He apparently only sought higher-than-book-value prices for his corporate clients when they sold shares to raise growth capital.

 

But, the consequences of this change, to earnings-capitalization pricing from book-value pricing, caused substantially higher price volatility. A stock market that multiplies earnings necessarily also multiplies the lesser inherent volatility of those earnings. As such, small changes in earnings could result in large changes in share prices and share prices could change, even if earnings did not.

 

For many investors, it was a change that increased volatility risk without increasing reward. Companies’ earnings growth rates did not increase; only volatility increased. Investors seeking all their returns from earnings-driven capital gains experienced more risk, but no more reward.

 

Other investors, however, did enjoy higher rewards as a result of the change to earnings-capitalization valuation. A market that multiplies companies’ expected earnings cannot effectively “de-multiply” companies’ expected dividends. It only subtracts current dividends as they are paid.

 

Future dividends, therefore, were not fully discounted in current share prices. Any investor who elected to collect those “free” dividends, enjoyed additional rewards that, over time, caused total returns to be greater than their companies’ earnings growth rates.

 

 

Not every investor is comfortable with the notion that dividends are “free” to investors choosing to collect them; they think there is a trade-off between dividend income and capital gains. They think more dividend income would cause lower capital gains and vice versa.

 

The market supervises this trade-off, they argue, by “arbitraging” future dividends into lower share prices. But, dividend-paying and, in particular, dividend-growing stocks have historically had higher, not lower, relative price/earnings ratios; an indication that no such discounting actually happens in practice.

 

The companies that pay dividends could have enjoyed higher earnings growth (and, thus, higher capital gains), other argue, had they retained and reinvested the cash. But, record-high levels of cash belie this reinvestment argument. More cash retained would more likely have increased companies’ cash reserves than earnings growth rates.

 

The most compelling argument about whether there is or is not a trade-off between dividend income and capital gains can be observed in the historical performance of the major market indexes, like the S&P 500.

 

 

The reason total returns were higher was dividends; specifically, 3.5% per year, in additional return, on average.

 

Obviously, those dividends did not reduce capital gains; capital gains were actually a little higher than earnings growth rates over the 40-year period. The dividends, therefore, had to represent payments that did not cause reductions in share prices. In effect, share prices were defined by expected future earnings, while dividends were paid from current or retained earnings. Combined, they delivered higher-than-earnings-growth total returns.

 

And, if investors had owned only the dividend-paying stocks in the S&P 500, their average annual total returns would have been even higher at 11.5%.

 

 

This discussion was inspired by the many concerns investors are currently expressing about their prospects for adequate future returns from common stocks.

 

Investors are concerned about many things. They are concerned when share prices fall, despite rising earnings. They are concerned that such divergent trends predict poor earnings and poor investment returns in the future.

 

There is also a constant barrage of negative predictions from economists, analysts, and media critics. Pimco’s all-star bond manager, Bill Gross, has captured the market’s mood with his predictions for “new normal” economic and stock market growth; growth at about one-half historical growth rates due to global de-leveraging, too-high governmental deficits and debts, and the higher taxes need to fund them.

 

Half  of historical nominal GDP growth would be about 3% per year, on average. By implication, that would also mean 3% for companies’ earnings growth and, also, 3% for general market share price appreciation.

 

Though we see the same causes for concern, we are reluctant to validate such gloomy forecasts because economic forecasts are notoriously wrong. Famed economist John Kenneth Galbraith once observed that, “There are two classes of forecasters – those who don’t know and those who don’t know they don’t know.”

 

But, what if the consensus is right; this one time? What if economic growth is 3% per year for the next decade?

 

Even with 3% GDP growth, investors can easily build quality portfolios that generate 4% current dividend yields, as well. Recalling that there is no trade-off between dividends and capital gains, these portfolios would logically deliver 7% total returns (dividends, dividend growth, and capital gains), over time, not just 3% from capital gains.

 

And, at 7% per year, on average, a pre-retirement portfolio housed in an IRA or 401k plan would double in value over the next ten years; and, double its dividend income stream to an annual amount representing an 8% yield on the original dollars invested today.

 

Collecting dividends may have enhanced investors’ total returns in the past, but will higher absolute and relative taxes take away that “free lunch” in the future?

 

Three months ago, significantly higher taxes seemed inevitable; recent events suggest that conclusion might have been premature. Higher taxes on dividends might not affect all tax payers, either; those with less than $250,000 in taxable income may be largely unaffected. Institutions representing over 90% of trading volume are either tax-exempt or short-term tax payers. Most mutual funds are tax-indifferent and alternative investments, like high-quality municipal bonds, offer no particular after-tax premium.   

 

In addition, higher taxes on dividends would not necessarily drive investors away from dividend-paying stocks any more than higher taxes on interest would drive investors from bonds. Since there is no trade-off between dividend income and capital gains, knowledgeable investors will not likely shun dividends because they would not receive any off-setting capital gain benefit.

 

And, when dividends were taxed at relatively higher rates before 2003 (often at much higher rates), their total returns, on average, were higher than non dividend-payers.

 

 

If dividends are taxed at higher marginal rates, some investors worry that companies might be less inclined to pay them; preferring stock buybacks or cash accumulation, instead. This is, of course, a possible reaction. So far, however, the reaction has generally been just the opposite.

 

There are some notable examples, lately, of companies actually advertising their commitments to dividends. One foreign bank advertised that it paid the highest dividends of any bank in the world. A large insurance company recently advertised that it had paid $60 billion in dividends to policyholders over the last 25 years. A mid-states utility recently trumpeted the payments of its 400^th consecutive quarterly dividend (that’s 100 years).

 

Rather than discouraging dividends, the tepid outlook for price appreciation may actually be encouraging them. According to a recent report by Oppenheimer, “The number of S&P 500 companies increasing dividend payments has risen sharply over the past several months… [and] each of the ten sectors of the S&P 500 has instituted dividend increases over the past two quarters.”

 

Closer to home, among stocks widely-held in ThomasPartners client portfolios, there have been 28 announced dividend increases over the last two quarters with increases averaging a little over 7%.

 

We note that these pronouncements and dividend increases were made long after managements were aware of possible increase in tax rates and the impending headwinds to economic growth and, thus, share price appreciation.

 

 

There is no historical reason to assume that recent decreases in stock prices portend anything about future price trends; the stock market has a notoriously-bad predictive track record. Recently-anemic economic growth, however, is more worrisome; economic growth rates coming out of a severe recession are generally more robust.

 

In our opinion, there is no magic growth elixir; stimulus programs, if well executed, can “kick the can down the road” a bit, but cannot make the problems go away. If not well executed, they can do more harm than good. Sustained economic growth in non-governmental sectors is the only enduring remedy and such growth cannot be realized until many systemic problems are effectively resolved.

 

On the other hand, forecasts for companies’ earnings are not as depressed, or as depressing, largely because most companies can compete in faster-growth foreign markets. They can control their costs better than governments, too. Share price and dividend growth could, therefore, easily outpace GDP growth for some years to come.

 

Eventually, however, companies’ earnings will succumb to slower economic growth. As demonstrated, however, we believe that investors can address these challenges by supplementing their potentially-lesser capital gains prospects with the higher current dividend yields currently available. Because dividends do not “punish” share price appreciation potential, investors can still earn attractive total returns indefinitely into the future.

 

In other words, our expectations for future total returns from owning common stocks is far more sanguine than that of the average market pundit; who may not understand that there is no trade-off between dividend income and capital gains. They look only at volatile share prices and miss the potential rewards from a long-term commitment to collecting all those “free” dividends.