We are all widows and orphans now
It may seem like a world turned upside down: stocks are desired for their dividends and bonds are all about capital appreciation, or at least preservation.
It was all so different over much of the past 20 years, when despite steady falls in inflation and rising prices for bonds, the real money was perceived to be in equity price gains.
Dividends were for widows and orphans; those without the knowledge or guts to take the big risks and make the momentum plays.
The truth is that we are all, if we are lucky enough, eventually widows or orphans.
Now, for reasons of fashion and reasons of structure both the importance of and the demand for dividends are likely to grow.
The past decade though, we’ve been living and investing like rock stars, largely ignoring dividend growth. The results are clear; lousy returns but higher and higher turnover within equity portfolios as investors chase momentum and the next big thing. This generates lots of fees and helped to drive a growing share of GDP for financial services but has not served the interests of investors well.
“To those with an attention span measured in longer than milliseconds — who are few and far between, to judge from today’s markets — dividends are a vital element of return,” James Montier, a member of the asset allocation committee at fund managers GMO wrote in a letter to shareholders.
Taking U.S. equity market data since 1871, Montier has worked out that when you look at it on a one-year time horizon nearly 80 percent of the return has been driven by changes in valuation. However, on a five-year view, a much more meaningful period, 80 percent of returns are actually generated by dividend yields and by dividend growth.
Taken over the very long term the importance of dividends and dividend growth has been even more important, driving about 90 percent of total returns.
Part of the move away from dividends in the past 20 years can be explained by a quick look at many top executives’ contracts: stock options mean they get paid not for driving total returns over longer periods but for driving up their companies’ stock over two- or three-year horizons. That led, at least until the crisis, to a huge substitution of stock repurchases for dividends.
Montier points out that demand for equities by investment banks seeking hedges for structured products has given rise to a dividend swap market that seems very attractively priced. For European shares, dividend swaps, where you buy the stream of income rather than the equity that produces it, are priced currently as if dividend performance going forward will be worse than it was in the Great Depression.
LOW GROWTH, DIVIDENDS AND DEMOGRAPHICS
Two factors — the likely low growth the developed economies face in coming years and the aging of the population — should combine to increase the focus on dividends and support the value the market places on a secure and growing stream of cash from a company.
Firstly, demographics. Older, often retired investors have long been the natural buyers of dividend shares. They seek income and a bit of growth, lest they outlive their portfolio. Considering the terribly low yields on offer in government bonds and the fact that the United States and Europe is aging, it is fair to reason that more investors will buy, and drive up the prices of, shares they think will provide income.
Secondly, there is a reasonable chance that interest rates stay low for a good bit longer than the “extended period,” the Federal Reserve promises. Developed economies are heading for at best a growth slowdown and very possibly another recession. The upshot is that there will be even less competition from fixed income instruments for the ever-growing widows’ and orphans’ dollar. A look at the recent 100-year bond from railroad Norfolk Southern, yielding a measly 5.95 percent, is a case in point. Demand was so strong that the railroad more than doubled the size of the issue to $250 million.
Of course, if we move into deflation many companies will be unable to make profits and will cut dividends. At the same time, the overall dividend yield of the stock market will rise as company managers seek to attract equity capital by better compensating it.
That is exactly what happened during the often deflationary period in the late 19th and early 20th centuries; equity yields were a good bit higher than bond yields because equities were seen as a good bit riskier.
So, two easy predictions: focus on dividends will increase and Wall Street will come out with new “value added” dividend-related products, complete with an extra layer of fees.