Tools & Resources▼
(Editor’s note: I’m vacationing in Alaska through mid-August, knocking off the last state I’ve yet to visit. During this time, I’m sharing insights into topics I’ve found of interest and hope that you do too. Today’s is a personal favorite—dividends.)
I may have mentioned to you in the past that I am the dividend girl here at Federated Investors. And so my presentations during my travels always include discussion on why dividends are appropriate even as we at Federated are secular bulls. Long-term, as I’ve said many times, we are quite bullish. But as you may recall from the comments from my doctor and dentist that I mentioned in last week’s missive, a lot of people do not believe in this market. Everywhere I go, advisers tell me their clients are worried about a big correction or something worse.
There is an antidote for this. Everyone in our business learned a long time ago that since 1926, dividends have accounted for approximately 41% of the average 9.9% total return generated by the S&P 500. Everybody knows this … and it is not true! It is not true because if you hold a dividend-paying stock, you also get the growth of that dividend. And since 1926, dividend yield plus dividend growth have accounted for 89% of the total return generated by the S&P. The remaining 11% can be attributed to valuation changes, what we in the business call P/E multiple expansion or contraction.
Now, if we look at returns decade by decade since the 1920s, we find two periods with the greatest P/E multiple expansion: the 1950s, (the postwar industrial revolution), and the 1980s-90s—what I call the “Madonna” years where a lot of “fake’’ earnings were part of that expansion and we paid the price in the decade that followed with big multiple contraction. Today, people think the stock market is expensive. Why should I buy stocks when they are at all-time record highs? And aren’t P/E multiples too high? Well, at the end of 2013, the P/E on trailing earnings was 17. At its peak in 2000, it was 28.6 times! That was at the tail end of the Madonna years. Who remembers back in 2000 at the holiday parties, where we would boast to our friends that we just bought a stock two weeks ago and it’s already up 30%. “Oh really, what are their profits?” “Actually, they don’t even have sales yet.’’ That is what it was like then.
While we are bullish long term, we are not expecting P/Es to go that high. Our bullish call does not rely on heroic P/E multiple expansion at all—maybe to 17.5 year-end, and slightly higher over the next few years. What it calls for is earnings growth that is driven by economic growth and relatively benign inflation. History shows there is no better correlation between the P/E multiple and any factor than inflation, and if inflation stays moderate and stable, this is supportive of higher multiples. That is, the current environment provides good cover for this bull, even though we are not expecting anything close to a 28.6 P/E.
If one doesn’t expect the ridiculous multiples of the Madonna years to occur again, it means dividends and dividend growth will have to account for most of the total return over time. Back in the Madonna years, Microsoft was the coolest company on earth and it wouldn’t have anything to do with dividends. Now, Microsoft and the coolest tech companies are flush with cash and dividends are becoming commonplace.
Bhirud Associates notes that corporate America continues to increase dividends at an above-average rate. So powerful is the recovery in dividends from the depressed levels of 2009 that dividends, as of Q2 2014, are up 29.6% over Q3 2008, which had been the highest dividend level. Yet in spite of the increase in dividends, the dividend payout ratio for the S&P, at 33.5% of earnings, is still at the low end of its range for the last 88 years. The current dividend payout ratio is also significantly below the median ratio of 53.2% for the period from 1926 through 2013.
Over the last five years, people have toggled between worrying about inflation, then deflation, then inflation, etc. What if inflation globally stays lower than expected and rates stay lower longer than expected—the Fed says we are not going to get back to normal highs; what good does that do me? I’m an aging baby boomer. I’m supposed to be investing more conservatively. I’m supposed to be focused on yield and safety. Historically, this has meant U.S. government bonds. But in this current environment—one in which we at Federated believe will be very challenging for bonds and very bullish for equities—if I’m in bonds, I may not receive enough yield for a while, and as interest rates rise, I will likely lose money.
I am an aging baby boomer who wants a big portfolio when I retire. My 401(k) is 100% in dividend strategies. People say, “Why would you put a dividend strategy in a 401(k)? You don’t need the money; you don’t need the income.” I say, “For total return, that’s why.” We do dividends for total return.