Thursday, December 14, 2017

Dividends Are The Investors' Friend

I recently learned that John Bogle had mentioned my humble blog in his latest book "The Little Book of Common Sense Investing" from a book review by my friend Mark Seed.

Some excerpts from this article on dividends was mentioned at the end of a chapter on dividend investing titled " Dividends Are The Investor's (Best?) Friend". The chapter discusses the important contribution of dividends towards total returns for the US stock market since 1926. The chapter also discusses the importance of reinvesting those dividends over time. I like how he focused on the stability of dividend income over time, placing a chart of S&P 500 dividend payments since 1926. The only major declines in dividends occurred around the Great Depression in 1929 - 1932, also in 1938, and during the Great Financial Crisis in 2008. The rest of the time we have a smooth uptrend in dividends as whole, as US corporations tend to gradually increase those dividend payouts every year since 1926. The chapter also discusses the importance of keeping costs low, in order to keep the majority of your dividend income. The book will also resonate with dividend investors, since it preaches investors to focus on their dividend checks, and ignore focusing on the fluctuating values of their investments

The book is worth a read by investors from all levels of experience.

I am beyond honored that John Bogle, who is a giant in the field of investing is even aware of my site. Actually, saying I am honored is an understatement.


Bogle is the founder of Vanguard, which is credited with introducing the low cost index funds to the masses, and pushed investment costs lower for millions of investors worldwide. As a result, those same investors get to keep a larger portion of investment returns. Bogle's message is simple, yet powerful - keeping costs low is the way to allow investors to keep their fair share of investment returns. The real noble thing he did was in setting up Vanguard's ownership structure, where each mutual fund holder is also a shareholder of Vanguard. The latter operates on a zero profit basis, and has the incentive to align the interests of mutual fund holders and keep costs as low as possible. As a result of the way Vanguard ownership is set up, Bogle didn't end up owning the giant. He walked out on billions he could have had. But, his name will live on for a long time, much longer than the billionaire heirs to Fidelity for example.

While I am known as a dividend growth investor, my approach is a fusion from a variety of broad investment disciplines, including indexing, value investing, long term investing, and momentum to name a few. When I was starting out more than a decade ago, I was influenced by several of John Bogle's ideas in formulating my investment approach.

- Keep costs low - earn your fair share of investment returns

When investors keep costs low, this means that they are able to earn their fair share of investment returns. Costs matter a lot in investing. If you generate an annual total return of 10% over the next decade, and you pay an annual cost of 2.20%/year to an adviser and a mutual fund, that cost would consume a full 30% of your investment returns over that decade ( this is due to the power of compounding). It is not fair to have come up with the investment capital at risk, but to only earn 70% of possible returns over that time period.

Dividend investors are acutely aware of the importance for minimizing investment costs. If you owned a dividend portfolio yielding 3%, and you had to pay 2.20% to a mutual fund manager and your financial advisor, you would be left with an yield of only 0.80%. In fact, the lower your investment cost, the higher the amount of dividend income you get to keep.

The high amount of costs is usually discussed as a percentage of assets. However, when you look at those costs as a percentage of dividend yields, it is obvious how high cost funds take a huge tax on your distribution income. If you pay a 1% fee to a mutual fund that should pay a 2% yield, you are in effect paying a 50% tax on your dividend income. This is a high tax that cannot be avoided by stuffing your investments in a tax-deferred account.

Another aspect of keeping costs low is making sure that taxes are minimized. I have achieved this by leveraging tax-deferred accounts such as the 401 (k) or Roth IRA. You can also achieve this by keeping investment turnover low, because frequent buying and selling of stocks generates a lot of taxable capital gains to pay each year.

Bogle reminds us that “When returns are concerned, time is your friend.  But where costs are concerned, time is your enemy.”


- Buy and hold long-term investing

Bogle is an advocate for a buy and hold investment strategy where you buy regularly for decades to come, all the way up to retirement. His strategy is focused on index funds, and I believe that most investors can definitely learn from this passive approach. When you buy and hold investments with the intention to hold for decades, you train your mind to think like a long-term investor, who is not going to get scared away when things get ugly in the short-term. The ability to stay the course is a trait that is very important for the success of the long-term investor. When you hold tight to your investments, you also spend less in transaction costs ( commissions, taxes, bid/ask spreads etc). This lets you keep your fair share of investment returns. Even more important is the fact that long-term investing discourages market timing, which is the erroneous belief that you can somehow miraculously get out of stocks before they go down, and buy them right before they go up. Noone can do this, and those who have done it are probably just lucky.

"The real money in investment will be made not out of buying and selling but of owning and holding securities."

- Expected Return Formula

I have used expected returns formula in my analysis of dividend growth investments. The formula is very simple, yet powerful. Your returns depend on three factors:

1. Initial dividend yield
2. Earnings Growth or Dividend growth
3. Changes in Valuation

In other words, if you invest in a portfolios of companies that yield 3% today, which also grow earnings and distributions at an annual rate of 7%/year, you can expect an annual total return of 10%/year if valuation stays constant. However, if valuations are high at the time of purchase, your expected returns will be lower due to valuation compression (P/E ratios will decline in the future). Alternatively, if valuations are low at the time of purchase, your expected returns will be higher due to valuation expansion ( P/E ratios will increase, returning to their mean).

Many dividend investors are familiar with the Chowder rule, where dividend growth and dividend yields are used together, in order to evaluate the effectiveness of investments. I believe that this Chowder rule is a derivative of John Bogle's expected returns formula.


- Dividends are more stable than capital gains

Dividends are more stable than stock prices, follow a general smooth uptrend, and provide a source of income that historically has grown faster than inflation. This is why Bogle tells investors to ignore stock prices, and focus on dividends.

When I read his book " Bogle on Mutual Funds", I found a lot of interesting ideas about investing. Many of these ideas have inspired me in educating investors on the Dividend Growth Investor website since 2008. Some of his quotes are listed below:

what is truly remarkable is that the record of dividend payments by US corporations heavily favors rising dividends over declining dividends, almost irrespective of prevailing business conditions. "

"Between 1926-1992, annual dividends increased in 57 years, declined moderately (less than 10%) in 4, and declined by more than 10% in another 5."

Dividends nicely exceeded inflation at a rate of 1.4%/year.

"Even when a company does not pay a dividend, investors implicitly value the firms stock based on the presumption of future dividends"



In fact, Bogle understands the needs of retired investors very well. " Finally, what's most important when we retire is the stream of income we need to support our needs - the dividend checks we receive from our mutual fund investments and the monthly checks we receive from our Social Security Payments".

Focusing only on the income, and ignoring the fluctuating value of those investments will resonate well for most retired dividend investors out there. With only a few exceptions during economic depressions, the dividends on US equities have increased almost every year since 1926. In fact, focusing too much on market prices can also lead to counterproductive behavior such as panicking and selling at the most inopportune times. And by keeping investment costs low, those retirees get to keep most of their dividend income to spend as they please.

- Reversion to the mean can take a long time

Reversion to the mean is an operation through which returns ultimately seem to drawn to some law of gravity. In other words, great returns do not happen in a straightforward fashion. You have a great deal of cyclical back and forth to take into consideration, if you take a large enough data sample. There is also an amount of randomness, even in long-term trends.

For example, between 1937 and 1968, growth stock funds did better than value stock  funds in the US. Anyone who did better probably believed that they are some sort of a stock market genius. Unfortunately, between 1968 and 1997 value funds did much better. Ultimately, growth funds did only marginally better than value funds during that period, which was characterized by an ebb and flow of performance, which ultimately settled at par.



The same reversion to the mean is observed in the performance of US stocks vs International stocks between 1959 and 1997. International stocks outperformed US stocks between 1959 and 1988. However, US stocks did much better between 1988 and 1997, which resulted in identical total returns for both asset classes since then.


Source: Bogle on Mutual Funds

Again, there is a cyclical nature of returns, which is subject to the gravity test of reversion to the mean. I always remind myself of this feature, when I look at data, because past performance is not a guarantee for future results.


- US companies provide foreign exposure through their global operations

While there might be some benefit to owning international stocks, there are also a lot of cons that investors need to be aware of. In general, I try to purchase US multinationals with long histories of dividend increases, which also have global operations. I have found that a large portion of US dividend companies revenues are derived from international operations, in some cases more than 50%. In my reviews of the largest companies in the S&P 500, I have found that these corporations generate anywhere from 40% - 50% of revenues from their international operations. Just by owning shares in all the companies in the S&P 500, you get exposure to international economies, without having to buy an international stock fund ( or build your own international portfolio from scratch)

As a result, I do not have to deal with currency volatility, foreign withholding tax rates, setting up brokerage accounts in 20 different countries and international accounting rules.

As the chart for reversion to the mean above has shown, along with this one from a previous post, international diversification has failed to deliver for long-term US investors for several decades. If we look at the performance of the Vanguard International IndexFund (VGTSX) against that of the Vanguard S&P 500 Index (VFINX), we can see that owning foreign shares has been a net loser for the US investor.


Source: Morningstar


It is likely that this trend will reverse at some point in time. Over a long investing timeframe, international diversification is unlikely to add much to returns.



Relevant Articles:

Is international exposure overrated?
John Bogle Likes Dividends
Dividend income is more stable than capital gains
Index Investing versus Dividend Growth Investing