Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
December 20, 2003
http://www.dynamicinvestors.net
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The last two weeks have really been something. I’ve barely been able to find the time to write. But fear not, faithful reader, I will not desert you.
Little Josephine was finally baptized last Saturday, a bit later than we planned. And you can always count on us to schedule a major production right smack dab in the middle of the busiest time of the year. We did it with our wedding, now we’ve done it with the baptism. I can’t tell if Chela and I are insane, or if we just enjoy the pressure. Maybe there’s no difference.
Okay, here we go. The Dow Industrials were full steam ahead this week, closing at 10,278.22, the highest since May 17, 2002. The Nasdaq and S&P both advanced this week, closing at 1,951.02 and 1,088.66, respectively. For the week, the Dow was up 2.4%, S&P 500 was up 1.4%, and the Nasdaq underperformed, up only 0.1%.
What can we say about this wonderful market performance? Only that I suppose it can’t go on forever. When it might come down, I don’t know, but I’ll be looking at this and more in my weekend update. Be sure to check it out.
The next week (week 3) of the subscription contest starts tomorrow. I’m still taking requests to enter, but get it to me quickly. And don’t forget to sign up for next week’s contest as well.
Don’t forget to check out the daily update on the Dynamic Investors site.
Enjoy the weekend, and don’t forget to sign up for the subscription promotion.
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Book Recommendation
Are you prepared for the coming economic crises?
If you read one financial book this year, make it Financial Reckoning Day. I’ve just finished reading it, and I can’t recommend it highly enough. Written by the author of The Daily Reckoning, the book delves into the history of markets, economics, politics, war, and just about everything else to figure out what’s going to happen in the future. I’ve been a huge fan of Bonner and the people at the Daily Reckoning for years, and I believe I’m a better investor (and person) for it.
Bill Bonner’s classic wit and humility really show through in Financial Reckoning Day. It’s a quick read packed with a tremendous amount of historical information and analysis. Yet Bonner never claims to know what will happen, but he paints a very convincing picture of what should happen. And it’s not a pretty picture. The story that unfolds in Financial Reckoning Day is one of foolishness, chicanery, and irresistible market forces that have already begun the work of dismantling the biggest lie in history: the world economy of the late 20th century.
Get a copy of Financial Reckoning Day, and enjoy it. Remember that the world won’t end tomorrow, but it could well be a very different place. Are you prepared to live in it?
For more must-have books, check out the Dynamic Investors Required Reading.
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The Importance of Dividends
Depending on who you ask, dividends can be anywhere from the most important quality in a stock to relatively insignificant. Dividends are a portion of a company’s earnings that are paid out to the shareholders. They’ve been around for many, many years in one form or another. They are an important method of distributing wealth to shareholders, and until the last few decades they’ve been the most significant factor in a common stock’s valuation. Thanks to tax policy changes, and the strange but pervasive belief that management knows best what to do with shareholder money, dividends have fallen out of favor over the last 30 or so years.
Dividends are basically a cash payout of quarterly profits by a company to its shareholders. It’s a distribution of earnings to the people who own those earnings: the company’s shareholders. If you’re a proponent of the bird in hand theory, which says that it’s better to have some cash in hand than to allow management to reinvest all of it, dividend paying stocks are popular with you. If, on the other hand, you believe that management is best suited to invest the residual earnings in high-profit projects, then you will avoid companies that pay high dividends.
Dividends were out of favor during the 1980’s – 1990’s bull market, as investors sought capital growth above all else. This was partially a result of laws that made it more tax-efficient to take long-term capital gains than dividends. But the belief that company management was better at finding market-beating investment opportunities than investors had also become a popular way of thinking. It was assumed that management could better identify profitable projects in the industry, and therefore the earnings should be retained and re-invested.
In fact, during the 1990’s boom dividends were looked upon as a negative characteristic for a stock. If a company was paying a dividend, it supposedly meant that management had no good ideas and couldn’t find investment opportunities. In many cases, what it really meant was the company’s management was free to burn the earnings up in any way they wished, and they certainly had a lot of matches.
It may seem counterintuitive to find stocks that return cash in hand to investors valued less than similar, non-dividend paying, companies. Yet for years, that has been the case. Tax laws played a part in this, favoring capital growth over dividend income. Until the Jobs and Growth Tax Relief Reconciliation Act of 2003 changed the tax law, dividends were taxed as income, at a higher rate than capital gains. Plus capital gains are only taxable when you sell, and if you believed in buy and hold for the long-term, you wouldn’t be paying taxes for many years.
So everyone jumped on the earnings reinvestment bandwagon, and forced the S&P dividend yield to historically low levels. This trend has begun reversing itself now that dividends are taxed at the capital gains (which they truly are) rate and not the income rate. It’s going to take some time, however, before dividends regain their historic importance. Yet, somewhere down the road I think they will.
Historically, dividends were considered risk mitigation for investors. A dividend offered the common stock investor one of the qualities of a bond coupled with the potential for capital appreciation. Common stocks are by nature riskier than bonds, and prior to 1958 investor’s demanded dividend yields higher than that of the long-term Treasury bond. Here is a chart of the S&P 500 dividend yield against the long-term Treasury yield.
Notice that during the depression, there were periods where the S&P 500 could be bought yielding between six and ten percent. In the deflationary period of the 1930’s, this was a fabulous return. The spikes in the dividend yield correspond to the fluctuations in the stock market, only in the opposite direction.
The high dividend yields during the Depression were necessary to entice investors into buying common stock. Most investors had given up on stocks by the early 1930’s in search of safer investments, pushing stocks down and yields up. If you had the foresight to invest $1000 in the S&P in 1932, when it was yielding 10%, you would have around $2 million today. But few people were willing to risk investing in common stock in 1932, which of course is why the opportunity was so good.
It’s interesting how markets work. They are constantly in search of balance, though rarely able to achieve it. There is a saying that “all things eventually revert to the mean”. This is especially true of markets, such that a market which rises must also fall, and a market that falls must eventually rise. All in an effort to reach the unattainable mean. The market provides incentives for these shifts, this “reversion to the mean”. We see in the historic dividend yield that in periods where common stocks are out of favor, the yield rises as the market attempts to entice investors back into stocks.
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Three decades later, in the 1960’s, investors began to look at stocks more for the capital appreciation potential than the dividend. As a result, stock prices were bid up during the 1960’s bull market, pushing dividend yields below 3% at a time when long-term bond rates were rising. Since that time, the S&P dividend yield has remained below the long-term Treasury rate.
As we’ve noted, common stocks have some advantages over bonds that help to justify the lower dividend yields. The first advantage is the potential for capital appreciation. Common stock has unlimited potential for price increases, while bond prices are dictated by interest rates and can’t appreciate indefinitely. There is also the potential for increasing dividends. Companies generally increase their dividend payouts over time while bonds pay a steady coupon payment for the entire holding period.
The potential for increased dividends provides protection against inflation. Inflationary environments force interest rates up, increasing the yield investors require on their holdings. The only way for bond yields to adjust in an inflationary environment is for their prices to fall. Because the coupon payment on a bond is static, when the price falls the effective yield to maturity increases. This yield increase is required by investors to hold bonds.
The advantage that common stocks have during inflationary periods is the ability to increase dividend payments. As the inflated money supply makes its way through the economy it eventually inflates companies’ nominal profits. By nominal, I mean profits that aren’t adjusted for inflation. These inflated profits can then be passed on to investors in the form of higher dividends, thereby increasing the yield on the common stock, without the price falling. This is very important because it helps the stock hold its market value. You will find that historically, companies that pay dividends hold value better in rising interest rate (inflationary) environments than companies that don’t pay a dividend.
The reinvestment of dividends also plays a huge part in boosting the return on your stock portfolio. Conventional wisdom holds that common stocks have risen at 7% a year over the last 100 years. But that statistic is misleading. In Financial Reckoning Day, Bill Bonner sums up the fallacy in that statement by saying
“For a hundred years, according to popular interpretation, stocks gained ground at a rate of 7 percent per year – beating bonds, real estate, old masters’ paintings, everything. Little-noticed was the fact that 5 of those 7 percentage points came from compounded earnings, not stock market appreciation. Take that away, and stocks would have underperformed several other asset classes, including bonds.”[i]
“Compounded earnings” is another way of saying reinvested dividends. Smart investors know the importance of reinvested dividends. It’s directly related to the eight wonder of the world: compound interest. And we all know that there’s no better friend to the long-term investor than compound interest.
As if to reinforce this idea, here is a chart depicting the contribution of both dividends and capital gains to the S&P total return. You’ll notice that dividends contributed more to the total return every year until the late 1980’s, when the great bubble began forming. So, between 1928 and 2000, a total of 72 years, capital gains outperformed dividend reinvestment for 14 years. All consecutive and all at the end of the period. Not to mention that those 14 years encompassed the greatest stock market bubble of all time, which has now burst.
It appears to me that dividends are of great importance to someone seeking long-term investment success. They help to lower the risk of holding common stock, and when reinvested provide a good portion of your total return. I always recommend holding some dividend paying stocks in your portfolio, especially now that the tax on dividends is the same as that on capital gains.
Next week we’ll look deeper at the history of dividends, and try to identify some quality high-yield stocks.
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Quotes of the Week
"There is the trouble with thinking you know something: the range of error is much broader than the pinprick point of truth.”
-Bill Bonner, 12-18 Daily Reckoning
"A small debt makes a man your debtor, a large debt makes him your enemy."
-Irish Proverb
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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[i] Bonner, William. Financial Reckoning Day. Hoboken, New Jersey. John Wiley & Sons, 2003.
