Tuesday, March 24, 2015

Why Stock Charts Are Misleading for Dividend Investors?

As a dividend investor, I do not really look at stock price charts. The things I look for are trends in earnings and dividends, catalysts for further earnings growth, and whether the security is cheap relative to the other investment opportunities within my opportunity set. In other words, if I expect PepsiCo (PEP) to deliver the same growth as Johnson & Johnson (JNJ), but Johnson & Johnson is available at a cheaper valuation, I would buy Johnson & Johnson (JNJ). It won’t matter whether Johnson & Johnson is selling at a 52 week high, or 52 week low.

However, I know that for a lot of investors, they look at stock price charts for whatever reason. I believe that focusing only on stock price history is misleading, because it doesn’t show you everything you need to know about a security.

The missing link of course are dividends. One of the biggest lies told to investors is that stocks , as measured by S&P 500 or Dow Jones Industrial Average, went nowhere between 1929 – 1954 and 1966 - 1982. It might be true that stock prices were volatile but mostly flat, however dividends provided for a handsome return to those patiently reinvesting them through thick or thin.

For example, if let's look at the annual price performance of the S&P 500 between 1929 and 1954. The price in 1929 was 24.86 points, which was not reached again until some time in 1953. Based on looking at price alone, someone could incorrectly assume that stocks did not provide any returns to shareholders for a quarter of a century.

However, if you add in dividends, and reinvest them, you can see that someone who put money in 1929 broke even by sometime in 1937. This is a very interesting finding, because it shows that even during a period where unemployment was at 25%, industrial and agricultural production fell, GDP fell stocks in the US did well for the long-term shareholder who was not afraid.  In fact, during that 25 year period, the whole return on US equities came from reinvested dividends. Over that period from 1929 to 1953, a $1000 investment quadrupled in value.

Let's also look at the 1966 - 1982 period for US stock prices. Again, I used historical annual data for the S&P 500. You can see that between 1966 and 1982, the S&P 500 increased from $93.32 to $117.28. If you look at reinvested dividends however, you can see that a $1000 investment at the end of 1966 pretty much doubled in value during that period.

Dividends usually accounted for 40% of average annual total returns. They are always positive, and more stable than capital gains, which makes them as a reliable source of income in retirement. Interestingly enough, prior to 1994, the yield on US Stocks was averaging around 4%. Incidentally, a researcher found that it is “safe” to "withdraw" 4% of your portfolio in retirement. I say incidentally, because it is clear that this researcher inadvertently makes the case that the safe 4% average annual spending comes entirely from dividends and the high interest income that was prevalent at the times. For those in the accumulation stage, the thing to remember is that reinvested dividends have accounted for 97% of stock market gains since 1871.

The shortcoming of stock charts is also evident when looking at individual companies returns over time.  Another thing stock price charts miss is spin-offs. Altria (MO) is a prime example of this, if you look at historical charts on Yahoo Finance. To anyone who only looks at the chart, and ignores everything else, it looks like Altria has done pretty badly since 2007. In reality, the chart fails to account for the fact that Altria (MO) spin-off Kraft in 2007 and Phillip Morris International in 2008.

Those two spin-offs actually have confused a lot of institutions. For example, despite the fact that Altria had a record of consistently increasing dividends for over a quarter of a century, it was booted off the S&P Dividend Aristocrats index in 2007. Anyone who blindly followed the index, likely also sold their shares. In reality, Altria (MO) never cut dividends. Anyone who purchased Altria in early 2007, has been receiving growing annual dividends ever since. The only issue is that those dividends were generated from shares of Altria (MO), Phillip Morris International (PM) and Kraft Foods (KRFT) ( and later Mondelez (MDLZ) as well). This is why I am very skeptical about blindly following indexes - there could be lapses of judgment that stem from mechanical application of rules, without really giving much thought to the reality and facts involved.  This is also why I think it is important to analyze every company I own, or expect to own in detail. Luckily, when Abbott split in two in 2013, the mighty S&P Dividend Aristocrats committee decided to keep both Abbott (ABT) and Abbvie (ABBV) in the index. Either way, I focus on the dividend champions index, which is the most complete list of US dividend growth stocks I know of.

The spin-off situation at Altria also confused a lot of "chartists" that appear on CNBC. You might want to check this article - it blatantly ignores the fact that the split from 2007 and 2008 ever happened.

To summarize, stock price charts only show one part of return that investors would have received. However, without taking into accounts dividends, and the power of dividend reinvestment, you cannot understand what the total returns on an investment really are. It pays to research every investment in detail, before putting hard earned money to work there. In addition, it pays to own investments that regularly shower their investors with cash, in order to reduce the risk of outliving money in retirement. As we was above, stock prices can remain flat for extended periods of time - anywhere from 16 to 25 years. If you only rely of capital gains to bail you out, you might be in for some nasty surprises if you happen to invest during one of those periods. An investor who expects to live off the dividend stream generated from their portfolio can afford to ignore stock price fluctuations, and enjoy the retirement that they have worked so hard to achieve. An investor who wants to sell of portions of their portfolio will be in real trouble if that portfolio doesn't pay dividends and share prices fail to increase.

Full Disclosure:

Relevant Articles:

Altria Group (MO): A Smoking Hot Dividend Champion
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
S&P 8000 – The power of reinvested dividends in action
Dow 370,000
The case for dividend investing in retirement

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