Dividends Matter And More So During Inflationary Periods

As noted in a number of earlier posts, at HORAN Capital Advisors, we use the dividend paying actions of companies as one way to evaluate a company's future growth expectations. In some ways, the dividend actions by companies provide investors with insight into management and the board's expectations of a company's future earnings prospects. This valuation methodology is what led to using the "dividend discount model" as a way to value companies. Importantly, the DDM can further be used to relate the value of a stock to a company's fundamentals.

Generally, companies do not want to reduce or slow their dividend growth rates as investors in these types of companies have come to expect a certain level of dividend growth or income growth. If the growth rate slows or other financial ratios begin to trend in the wrong direction due to a company's desire to maintain a certain dividend growth rate, this provides investors with important insight into the future return potential for a stock.

Additionally, as noted in a recent research report by Fidelity's Market Analysis, Research & Education group, dividends are a critical component of a stock's overall return. The opening paragraph of the report notes,

"Companies that regularly return some of their profits to shareholders in the form of stock dividend payments are predominantly mature businesses that have steady cash flows, relatively stable profit outlooks, and lower operational risk on average than non-dividend-paying companies. These characteristics generally have led to less share price volatility for dividend-paying companies compared to the broader market. Typically, a company does not start paying stock dividends unless it is confident it can continue to generate enough earnings to distribute dividends on a regular basis going forward. The primary reason: cutting a dividend may be interpreted by investors as a negative statement about the company’s profit outlook, which may result in a decline in the company’s stock price."

One aspect of the current actions by the Federal Reserve, specifically, round two of quantitative easing (QE2), concerns us at HORAN in that it is likely to fuel inflation at some point in the not too distant future. In an inflationary environment though, stocks actually perform okay when looking at the entire inflation cycle. Our post titled Where To Invest In An Inflationary Environment addresses this point.

The Fidelity report also notes during the period 1974 - 1980, the rate of inflation was 9.3%. During this time period the return on the S&P 500 Index averaged an annual rate of return of 9.9%. The dividend component of this return (4.9 percentage points) accounted for nearly one half of the overall return as can be seen in the below chart.

From The Blog of HORAN Capital Advisors

In conclusion, certainly, the level of dividends paid by companies have declined in recent decades; however, this decline seems to be reversing at the moment. More importantly, dividends continue to represent a critical component of the total return on stocks. And when, not if, we see inflation increase, this inflationary impact will be more favorable for stocks than for fixed rate bonds.

From The Blog of HORAN Capital Advisors

Source:

Realizing the Impact of Stock Dividends (PDF)
MARE
Fidelity Management &Research Company
November 12, 2010
http://personal.fidelity.com/products/funds/content/pdf/realizing-the-impact-of-stock-dividends.pdf

Dividend Actions As A Forecasting Variable

One reason we review a company's actions in regards to its dividends is these actions can provide insight into the potential direction of a company's stock price. Additionally, the broader dividend actions of companies in the S&P 500 Index can provide insight into the market's future direction as well. In as much as dividends are important, it is really the insight that dividends provide into a company's future cash flow expectations and the quality of its earnings.

The below chart graphs the S&P 500 Index returns for the seven year period (2003 - 2009). Admittedly, this is a short time period and I will attempt to post an analysis of the data over a longer time period in the near future. The graph also includes the positive dividend actions within the index lagged, or pulled forward 1-year. The correlation coefficient of the two data sets is .7775. This high level of correlation suggests that an investor's ability to forecast dividend actions can have a positive impact on ones investment returns.

From The Blog of HORAN Capital Advisors

We have written a number of articles on our blog that addresses the importance of dividends and the role they play in assessing the quality of a particular company's earnings.

• Dividends Matter And More So During Inflationary Periods
• Dividend Payments Likely To Improve?
• For Dividend Investors, It Is All About The Cash
• Comprehensive Review Of The Dividend Aristocrats

Dogs Of The Dow Update: As Of June 21, 2019

With the first half of 2019 nearing an end, the Dogs of the Dow strategy is keeping pace with the Dow Jones Industrial Average Index. However, the Dow Dogs for 2019 trail the return of the broader S&P 500 Index. The Dogs of the Dow strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Average Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds that portfolio for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

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Income Yielding Equity Sector Valuations Near Historical Highs

Towards the end of 2015 and far ahead of the BREXIT induced market downturn, investors began to seek the apparent safety of income yielding equities. The initial motivation for this seems to have been investors seeking yield outside of fixed income where yield seems hard to find in this low interest rate environment. The consequence of this pursuit of yield is the valuation of some of the defensive, income yielding sectors has been pushed to extremes. This move towards higher valuations has been exacerbated by the BREXIT outcome. One example of this is the utility sector.

The below chart displays the performance of the S&P 500 Index sectors for the year to date period through June 27, 2016. Three of the top performing sectors are viewed as defensive ones and tend to be comprised of companies that pay and grow their dividends, i.e., utilities, telecom and consumer staples sectors. The top performing sector is utilities garnering a return of 19.8% so far this year.

Of importance, investors should keep in mind the utility sector is trading at a near record valuation based on the sector's forward price to earnings ratio of 17.8 times (blue line.)

Other sectors such as consumer staples and energy also trade at higher valuations or P/E multiples as well. Yardeni Research ($$) updates sector valuations on a periodic basis and their most recent report can be read here. Sectors, and for that matter specific stocks, can remain elevated from a valuation perspective for an extended period of time. However, when rates rise and/or a more risk on equity environment returns, these defensive sectors are likely to underperform.

S&P Dow Jones Indices and Factset recently highlighted the continued growth in cash balances for S&P 500 companies. A part of this cash growth has gone towards dividend payments and stock buybacks as I noted in a post yesterday, Stock Buybacks Up Double Digits In First Quarter, In Factset's report released today, they acknowledge the growth in cash levels; however, they also note the Cash to Debt Ratio for S&P 500 companies (ex-financials) has fallen to its lowest level since the second quarter of 2009. And back to utilities, six of the top ten companies with the lowest cash to debt ratios are utilities as can be seen in the below table.

There is more to valuation than simply looking at cash/debt ratios, and utility rates are regulated and maybe more sustainable from that point of view, but higher demands on cash due to debt payments can become an issue for utility companies. Just last month Moody's downgraded the long-term senior unsecured rating of The Southern Company (SO)to Baa2 from Baa1 due to increased debt levels and lower cash flow coverage resulting from an acquisition.

For investors pursuing investments in higher dividend yielding equity sectors, paying attention to valuations and coverage ratios is important. Additionally, not if, but when a risk on equity environment returns, these defensive, income yielding stocks could come under pressure.

Dividends Do Matter

With the increase in market volatility over the last month, and mostly on the downside, dividend payers, on average, lost half as much as the non payers according to Standard and Poor's. S&P notes:

The dividend, to some extent, acts like an anchor, slowing the stock movement down since there is an actual cash payment. That means swings in these stocks prices, during both good times and bad, aren’t as dramatic as their non-dividend paying peers.

Standard & Poor's analysis looked at the payers versus the non payers going back to 1979 and they found:

• Payers did 2.24% better per year compounded than the non-payers.

• Translated from an initial investment of $10,000, non-payers would now be worth $262,237 vs. a worth of $451,458 for the payers, a difference of 72%.

• The difference between the payers and non payers is 2.24%, which is the dividend yield.

Source:
Payers Pay ($)
Standard & Poor's The Outlook
By: Howard Silverblatt and Beth Piskora
August 29, 2007
http://sandp.ecnext.com/coms2/page_outlook

The Impact Of Higher Taxes On Stock Prices

In an effort to look past the health care rhetoric, one aspect of the legislation that we know is coming is higher tax rates. In addition to the higher taxes that are a apart of the new legislation, the Bush tax cuts will expire after 2010 as well. So what does history say about higher taxes and stock prices.

It has been 23 years since capital gains tax rates were increased. The last increase occurred when Ronald Reagan was president. A big part of what Reagan did with taxes was lower the highest marginal tax rate on income from 50% to 28%. However, Reagan did increase the tax rate on capital gains from 20% to 28% beginning in January 1987. What occurred in 1986 was the unleashing of the corporate raider. A recent article in Financial Advisor magazine noted:

It was the age of the corporate raider and folks like T. Boone Pickens. Carl Icahn and Ronald Perelman were making the CEOs of America's biggest companies quake in their stretch limos. With a huge assist from Drexel Burnham Lambert's junk bond department in Beverly Hills, these characters were putting companies into play on a weekly basis. The rest of Wall Street was frantically scrambling to clone Drexel's incredible profit machine and struggling to create their junk bond units to finance LBOs....

When the 1986 tax act became law, these raiders sensed opportunity and took off on a bender that would last for more than two years. Shareholder value was their mantra. Almost every day, they would tee up companies and demand that their boards work over time to quickly complete the deal to give shareholders the full advantage of the soon-to-expire 20% capital gains tax rate. In actuality, most raiders were hoping that a bigger corporation, or so-called white knight, would swoop in and trump their offers.

Did the expiration of the 20% capital gains tax rate in January 1987 hurt stock prices? Hardly. From January to September, equities went crazy. Propelled perhaps by the big cut in income tax rates, the Dow climbed from 1,897 to over 2,700 on August 25 in a frenzy that looked like a runaway train going down Mt. Everest.

The fall out from this junk bond era is well know, but it is worth noting that stocks performed well during this time period. For bond holders, they should have some knowledge of history.

Fed chairman Paul Volcker discerned the all-too-obvious symptoms of an overheating economy and decided he'd had enough of all this nonsense. In April, he jacked up interest rates dramatically, triggering a $100 billion bath for bondholders around the globe.

One aspect that is different this time is income taxes will be on the rise. David Kelly, chief market strategist for J.P. Morgan Funds notes:

• starting in 2013, the Medicare tax rate on households with income over $250,000 will be increased from 1.45% to 2.35%.

• a new 3.8% Medicare tax will be introduced for this same group on investment income.

• the tax rate on dividends and long-term capital gains will increase from 15% to 20% for households earning over $250,000 and with the new Medicare tax, these rates will rise to 23.8% for the same group.

• Under current tax law, investors get to keep 85% of the income stream from taxable stock market investments. Under this new law this will be cut by 8.8% to 76.2%, reducing the value of the income stream by 10.4% (that is 8.8% of 85%).

• using a number of broad assumptions, the value of the average stock should be reduced by one quarter of 10.4% or 2.6%—not good obviously, but also not an overwhelming reason to avoid stocks after a 12 month period in which they rose by over 70% and still appear undervalued.

Certainly, an investor's income stream will be impacted by the higher tax rates. The question becomes what are the alternatives to stocks and dividend paying stocks for that matter? If the Fed is preparing to raise interest rates (maybe not until later this year), what will be the impact on bonds? Additionally, with the precarious budget situation with a number of municipalities, tax free bonds may not be the safe haven expected by many investors. In short, don't let the tax tail wag the dog. Some perspective on history is contained in the article, Animal Spirits: The Last Time Capital Gains Taxes Rose.

Source:

Animal Spirits: The Last Time Capital Gains Taxes Rose
Financial Advisor Magazine
By: Evan Simonoff
March 25, 2010
http://www.fa-mag.com/blog/evan-simonoff/5357-animal-spirits-the-last-time-capital-gains-taxes-rose.html

Investment Implications of Health Care Reform
Financial Advisor Magazine
By: David Kelly, chief market strategist for J.P. Morgan Funds
March 22, 2010
http://www.fa-mag.com/online-extras/5344-investment-implications-of-health-care-reform.html