The financial media and blogosphere have been awash in commentary over the past few weeks talking about the death of individual investor interest in the stock market. Josh Brown at The Reformed Broker lists five reasons why investors are rightfully frustrated. Ron Lieber at the NYTimes had a much talked about article providing investors with alternatives for those “fed up” with the stock market. There is no doubt some of the disgust with the stock market has to do with the still ongoing “lost decade” which we discuss in the final chapter of our book, Abnormal Returns: Winning Strategies from the Frontlines of Investment Blogosphere.
There is more to this ongoing disgust than the lost decade. There is good reason why investors should be fed up. The much hyped Facebook IPO not only blew up but has helped drag down the entire “social media” theme. Just last week a colossal screw up on the part of trading firm Knight Capital ($KCG) put the stock market into a tizzy. Jason Zweig at the WSJ notes how many investors can’t stand to see their stocks whipped around by the likes of these flash crashes.
Interestingly while much attention has been focused on investor anxiety an increasingly recognized theme has been the rising interest in dividend focused investing. Not surprisingly the ETF industry has taken the dividend theme and run with it. The number of ETFs, both domestic and global, with “dividend” in the name keeps growing. So much so that some analysts have asked whether we are in fact in a “dividend bubble.” Putting aside the fact that the term bubble is thrown around way too much, I would argue that the rising interest in dividends represents a return to a more fundamental approach to investing.
A discussion of dividend investing is about as far removed from discussion of high frequency trading or social media than you can get, and that is over the long run a good thing. Henry Blodget writing at Daily Ticker notes how many analysts, including bond bigfoot Bill Gross, tend to forget that historically dividends have provided the bulk of equity returns. We noted many times that “dividends matter.” Now it seems like the rest of the world is beginning to pay attention.
Research by Dimson, Marsh and Staunton has shown not only this fact that dividends provide a significant part of equity returns. They have also shown that within and across markets higher dividend payers tend to outperform the market averages. The best part is that higher dividend yield stocks are no riskier than their counterparts. None of this should be altogether surprising to those steeped in financial history.
There is a new book, The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham, on the father of value investing Benjamin Graham by Joe Carlen that was recently reviewed in the WSJ. There is also a post up by David Larrabee at Enterprising Investor looking at the work of John Burr Williams, author of the classic The Theory of Investment Value. For those not familiar with Williams he developed the dividend discount model that was for a long time how financial analysts valued companies. Williams viewed earnings as simply a means by which companies can pay dividends. In short, a review of the investment classics can help ground us when trying to analyze the ever changing market scene.
To be clear, a simplistic approach to dividends is just as likely to lead an investor astray than it is to enlighten. Some argue that certain sectors, like utilities, have become overvalued given investor demand for dividend yield. A naive approach to yields can also fool investors. Jason Zweig writing at WSJ notes have some closed-end funds have been able to maintain high “dividend yields” while simultaneously having poor returns.
It seems that corporate America has taken note of investor demand for dividends. It is now the case that 402 of the S&P 500 companies now pay a dividend, the most since 1999. Even Apple ($AAPL) now pays a competitive dividend. Given the record high profit margins that corporate America is now experiencing added to the fact that companies are holding historically high amounts of cash on the balance sheet bodes well for the continued focus on dividend payments.
A skeptic would argue that all of this interest in dividend yield is simply yield chasing. That is undoubtedly part of the current appeal of dividend-focused investing. Since last Fall the yield on the S&P 500 has exceeded that of the 10-year Treasury note. That has not been the case since the 1950s. So something has clearly changed in the relative valuations of equities and bonds. Eddy Elfeinbein at Crossing Wall Street has been pointing out cases where a well-known company’s dividend yield, like that of Johnson & Johnson ($JNJ) exceeds the yield on their own bonds.
There is another important aspect to this shift towards dividend yields. As the Baby Boom generation enters their retirement years we should not be surprised to see a secular shift in interest towards strategies that offer more stable returns and some income to boot. The Facebooks and Zyngas of the world clearly don’t provide that opportunity. Recent research indicates we may be in a period of muted equity market valuations due to demographic shifts. If that is the case then the more certain return of dividends looms even larger.
That is not so that dividend-focused investing is any sort of panacea. There are plenty of risks to be aware of. Dividend-paying stocks can go down just like a non-payer easily wiping out the return from dividends. A 10% pullback (or worse) in the stock market will not spare dividend payers. The looming ‘fiscal cliff‘ provides another risk. There is a good chance that taxes on dividends will increase starting 2013 muting the attraction of dividends. Another worry is corporate profit margins. If we see a sustained decline in profit margins this will make management’s less willing to initiate or increase dividends.
Some will argue that dividends as a way of enhancing shareholder value is overrated and that share buybacks are more flexible and efficient way of generating returns. Research shows however that companies that spent the most on bubacks did worse than those that spent the least. A cynic would say that companies favor buybacks because it works in the favor of option-laden management and not shareholders.
There are no safe havens in the financial markets. Risk is inherent in every investment. However a return to a focus on dividends implies a greater interest in investment fundamentals. Individual investors can’t trade against the algorithms and hope to win. All we can do is have a longer term focus and historically that means being aware of the power of dividends. In light of recent exchange hiccups many like Mark Cuban have been asking “What is the purpose of the stock market?”
It shouldn’t be to provide a playing ground for dueling computers, although they clearly have a role to play. The stock market, is as Cuban states, should be there “to be a platform for companies to raise money for growth and to create liquidity and opportunity for shareholders as it has been in the past.”
A return to this sort of market implies a return to fundamentals, not made-up metrics. The ultimate fundamental is dividends, a cash return on your investment. If your company is unwilling or unable to pay a dividend you had better hope that there is some notable growth on the horizon. In the meantime risks abound for dividend-focused investors including relative overvaluation, higher interest rates and/or a significant market correction. As investment strategies goes it seems difficult to see how one can go too far wrong, for too long, by focusing on companies with the ability and willingness to pay their shareholders a meaningful dividend.
*Yes I know there are a number of companies that consciously choose not to pay dividends, despite their ability to, including the sainted Warren Buffett’s Berkshire Hathaway ($BRKB), noted.