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Dividends: Forgotten again?

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“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” — John D. Rockefeller

 

In the last ten years, the markets have had an incredible advance since the lows of March 2009. During this remarkable period, investors have become infatuated with the FANG stocks (Facebook, Apple, Amazon, Netflix and Google) and, more recently, with the IPOs of “Unicorn” entities such as Lyft and Uber. All these stocks have benefited from a “goldilocks” economy that is growing modestly but not too fast and not too slow. Of course, the Federal Reserve has also aided and abetted this favorable environment by providing ample liquidity and historically low interest rates. This background appears so nearly perfect that it begs the question…”what could possibly go wrong?”

The answer to this timely question has several components that need to be addressed now while investors are enjoying the moment and well before conditions change that might cause investors to reexamine their current investment strategy. To do so requires a step back so that the current market euphoria can be viewed from an historical perspective.

Having been a value investment manager for more than five decades, the one thing missing from the recent market environment is an honest discussion of the role that dividends have played in contributing to the total return from equity investments over an extended period of time. Interestingly, according to the Ibbotson Year Book and Wisdom Tree, from January 1926 through the end of April, 2019, large-cap stocks produced an annual total return (capital appreciation plus dividend income) of 10.11% compared to an annual price appreciation of 5.96 %. In essence, dividends contributed just over 40% of the total annual return from large-cap equities over a 93-year period.

With those historical facts in mind, the equity markets based upon a variety of measurement criteria are not inexpensive and caution should be exercised in constructing an equity portfolio for the coming years. In doing so, it is best to keep in mind that the U.S. and world economies are slowing down and corporate profits are advancing at a slower pace. With interest rates on ten-year U.S. Treasuries at approximately 2.50%, the fixed income markets do not represent significant competition for an equity investor’s capital. Likewise, the current yield on the S & P 500 Index is about 2.00%. In this environment, a well-constructed equity portfolio comprised of companies with strong balance sheets, a solid position within its industry and managed by capable executives holds the promise of growing dividends over a five to ten-year period. Importantly, a portfolio of these types of companies will likely produce a dependable and growing amount of income, greater than a fixed income investment while having the added benefit of possible capital appreciation during the holding period.

This latter point has always been an important element in a value manager’s approach to stock selection. Often when value managers identify an attractive common stock selling at a substantial discount to what is believed to be its intrinsic value, the manager purchases the security not knowing precisely when the market will recognize the value in the stock, driving the stock price higher. Given this fact, value managers like their equity holdings to have an attractive dividend so that the client receives dividend income while awaiting for the expected capital appreciation. This dividend income is a source of comfort to the investor and the client and allows the requisite patience needed to be a successful value manager over the long term.

Another important component of value investing is the confidence generated by a company continuing to increase its dividend over time. Dividend action is implemented by the Board of Directors following a recommendation by the senior management team. As a whole, corporate directors are chosen for a Board based upon their intelligence and knowledge of the industry in which they function. As such, Directors are among the best informed individuals about a company’s financial position, its competitive position and its strategic plan for the future. Therefore, when a company raises the dividend for its shareholders, it is a clear sign that the company is on solid footing for the foreseeable future.

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MVP May 2019 Dividends-Forgotten Again

Stephen K. Kent, Jr., CFA
Founding Partner and CIO
Metis Value Partners, LLC

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