October 14, 2011
Written By John Buckingham
“Some have warned that income-producing stocks have become a ‘crowded trade.’ We would argue that the nearly 14% plunge during the third quarter in the broad-based S&P 500 index, where 389 members pay a dividend, suggests otherwise. To be sure, ‘defensive’ areas of the S&P, like Utilities (+10.7%), Consumer Staples (+3.4%) and Health Care (+2.5%), were actually in the green for total returns over the first three quarters of 2011, with the first two among the three highest-yielding of the 10 S&P GICS sectors. Of course, Financials (-25.2%) and Materials (-21.8%) have received little love so far this year, despite generous dividend yields of 2.5% and 2.7%, respectively.
“Considering that the forward (next 12 months) yield on the S&P 500 is now 2.5%, while the broader-based Russell 3000 Index boasts an annual payout rate of 2.4%, it is easy to see why pundits would extol the virtues of dividends, especially after non-income producing and formerly high-flying gold and silver became a little less precious last month. In fact, silver endured its biggest single-day selloff since 1987 when it plunged 18% on September 23.
“No doubt, many are far more concerned with return of principal than return on principal today, with many fleeing to the safety of cash. Of course, those that have decided to place their money into the modern-day equivalent of the mattress earn a whopping 2 basis points (0.02%) on average in taxable money market funds, according to iMoneyNet.com. Growth of capital is obviously not their objective, but it is amusing to note that at the current money-market rate, cash will double in 3,466 years!
“Others are ‘hiding out’ in U.S. Treasuries, where the yield on the 10-year note dropped below 2% last month and the yield on the 30-year bond actually tumbled below 3%. Incredibly, because inflation has averaged 3% per annum over the past eight decades, those willing to accept the current yields on the 10-year and the 30- year are likely to see an actual loss of purchasing power if they hold to maturity. And should they wish to cash out prior to the years 2021 and 2041, respectively, they risk capital losses.
“Clearly, equity investors must steel their nerves for heightened levels of volatility, especially as the European sovereign debt crisis remains front and center, growth in stronger economies like China and Germany has slowed and recent economic statistics in the U.S. have been far from robust, but relative to Treasuries, dividend yields are as attractive as they’ve been in 50 years. Aside from several months at the height of ’08-’09 Global Financial Crisis, the last time the yield on the S&P 500 was above the yield on the 10-year Treasury was 1958. And the big plunge in both interest rates and equity prices on October 3 moved the forward yield on the S&P closer to the 2.8% yield on the 30-year Treasury!
“What’s more, corporations have actually been boosting their payouts as more than half (258) of the S&P 500 members have either raised or initiated a dividend this year. While we know that analyst earnings expectations are likely still too high, even as they have been dropping in recent weeks, S&P (as of September 30) estimates that operating EPS on the S&P 500 will jump from $83.77 in 2010 to $97.98 this year to $111.37 in 2012. Hard to imagine dividends not rising further were earnings to come close to those projections, especially as corporate balance sheets are loaded with record levels of cash. Value stocks (those trading for lower fundamental valuation metrics) are providing even more generous income streams. Breaking down the Russell 3000 index into its Value and Growth components, one finds the former sporting a forward yield of 3.0% compared to a 1.8% yield for the latter. The forward yield on the Dow Jones Industrials matches that of the Russell 3000 Value index, so the attractive payouts are not just limited to Value stocks. It is nice to see the renewed interest in income, as we can’t forget that dividends and their reinvestment have long been a substantial contributor to the total return on equities. Data from Morningstar going back to 1927 show that through the end of last year, the income component of total return amounted to 41% for Large-Cap Stocks, 35% for Mid-Cap Stocks and 31% for Low-Cap Stocks. More importantly, our own analytical work going back 20 years and numbers we’ve crunched from Eugene T. Fama and Kenneth R. French dating to 1927 find that dividend payers have actually outperformed non-dividend payers over the long term and they have done so with lower volatility! Not quite the Holy Grail, but higher returns with lower risk is obviously a winning combination.
“Looking at our numbers (we divided the Russell 3000 membership into dividend and non-dividend-paying groups each year on August 31, then created a return series consistent with each stock’s actual weighting in the index), dividend payers have won the performance spoils over the past 20 years, returning 8.5% per annum, versus 7.8% for non-dividend payers. Fama-French tells the same tale as value-weighted data (through July 31) show that annualized returns since 1927 for dividend- paying stocks have ranged between 9.0% (the lowest 30%) and 11.2% (the highest 30%) compared to 8.4% for non-dividend payers.
“We also reviewed the annualized standard deviation of the trailing 36-month returns for both data sets (combining the dividend payers in the Fama-French series) to determine the spread of the numbers. Standard deviation is the square root of the variance with the variance defined as the average of the squared differences from the mean. In simpler terms, the greater the standard deviation, the more volatile the return and the higher the risk that the return will deviate from the norm. Interestingly, dividend payers, despite their greater return characteristics, have actually had lower standard deviation. Hard to argue with the historical evidence that dividend-payers deserve the lion’s share of any equity allocation, and we’ve been incorporating dividends into our valuation analytics for a long time now.”
John Buckingham, The Prudent Speculator, 10/4/11